Criticism of Capital Asset Pricing Model - Essay Example

?Financial Table of Contents Table of Contents 2 Part 3 Part 2- 7 Part 3- 10 Reference 15 Part Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) expresses the relationship between expected return and risk of risky securities. This is stated as- Re = Rf + (Rm-Rf)*? Re is the required return on the security Rf is the risk-free rate of return ‘?” is the market beta Rm is the market return As per CAPM the investors are rewarded in 2 ways: risk and time value of money. The risk free return compensates for the time value aspect of the investment. The remaining part represents the ‘risk premium’ where the market return earned in excess of the risk free rate is multiplied with the ‘beta’ of the stock. It is essentially the return for bearing additional risk (Investopedia, 2010). If the expected rate of return on a security is more than the required rate of return then the investment in profitable whereas if the expected return is less than the required rate of return then the investment is not profitable. Unlike Mean Variance Portfolio theory the CAPM model rewards for the excess beta or additional risk borne by the investor. Higher the beta higher is the compensation required by the security. As per this model a higher ‘standard deviation’ does not mean a higher return as ‘beta’ is the measure of risk under CAPM and not ‘standard deviation’. In the CAPM world an investor is rewarded for bearing the risk that cannot be diversified. This is referred as ‘systematic risk’ captured by the beta of the stock. An investor is not awarded for bearing any nondiversifiable risk i.e. unsystematic risk captured by the standard deviation of the stock. In other words the investors are rewarded for bearing the risk that cannot be diversified away. This is also referred as ‘market risk’ (Sigman, 2005). Assumptions under CAPM- The first assumption under this model is that the transaction costs do not exist. This means that the purchase or sale of an asset does not require any cost. The second assumption is that the CAPM model assumes all assets to be infinitely divisible. This implies that an investor can take a position in the market irrespective of their wealth position. There exists no ‘personal income tax’. This implies that an investor is not influenced by the nature of gain whether it is in the form of capital gain or dividend. There exists perfect competition. This means that a person cannot influence the stock price by going long or short in it. The investors base their investment decisions on the standard deviations of returns and expected value on their investment portfolio. There is no limit on short selling. CAPM also assumes that there is unlimited lending and investing at the risk free rate. CAPM assumes homogeneous market expectations. The last assumption is marketability of all assets (Elton, et al., 2009, p.283). Beta Co-efficient The beta is the sensitivity of stock return to the market return. Higher the beta higher is the risk associated with the stock. Gitman (2006) states that beta is “a measure of non-diversifiable risk” i.e. it measures the return on asset with reference to the market return. Ideally the beta of a stock should be “forward-looking” and measured with respect to the whole market, whereas in practice this is based on historical returns and the stock index acts as a proxy for ‘market return’ (Kurschner, 2008, p. 3). Suppose the beta of Stock A is 2. In the event of a 10% rise or fall in the market the price of Stock A will rise or fall by 20% respectively. Stocks with a beta of more than one are referred as ‘aggressive stock’ and stocks with a beta of less than one are referred as ‘defensive stock’. One can invest in aggressive stocks in times of market upswings and such stocks must be avoided in times of uncertain market conditions. In short the beta co-efficient of a stock measures the volatility in the return of a stock with respect to the market benchmark. Criticism of CAPM The assumptions of CAPM are considered to be unrealistic and do not hold good in the real world. The CAPM model assumes that there is no cost of trading. However in real life an investment involves significant amount of transaction costs. The CAPM assumes taxes to be nil. But in real life an investor is subject to capital gains tax that influences his choice of investment. The basic assumption of CAPM is that all the investors hold an identical portfolio. This is derived from the assumptions of nil transaction costs and homogeneous expectations. But some investors simply invest in a single stock instead of a portfolio i.e. they do not hold diversified portfolios. The evidence from the market has shown that the investors do not invest in the market portfolio. As a matter of fact they invest in “nonindexed mutual funds” by paying fees. The results have also shown that firm-specific risk is present in the case of large portfolios. The assumption of a risk-free rate is not realistic as there is some amount of risk associated with the government bonds as well. Ideally this model must be based on “forward looking data” such as expected beta and expected return. According to Brigham & Gapenski (1996) the calculations are based on historical data and cannot be exactly estimated (Kurschner, 2008, p.6). The CAPM assumes that beta is the only measure of risk. But in real life there are other risks like liquidity risk, inflation risk. Other than this CAPM assumes that the risk free rate of investing and borrowing is the same but this is not true as in the real world the rate of borrowing is more that the rate of investing (Palmiter, 2003). Part 2- Time-yield curve The yield curve is the graphical relationship between the yield to maturity and term to maturity. The “shape of the yield curve” helps in assessing the market expectations about the interest rates in the future. A rising yield curve implies that the market participants expect the interest rates to rise in the long term whereas a falling yield curve implies a fall in the long term interest rates. This referred to as Expectations theory. The future interest rate expectations must be interpreted cautiously as the shape of the yield curve is influenced by maturity and liquidity preferences. An investor can use the time yield curve in the interpretation of the market’s expectations about the future interest rates however he or she can have a different assessment about the future rate. By comparing one’s anticipations with the yield curve an investor can take advantage. For instance if the yield curve is upward sloping suggesting a market consensus of increasing interest rates whereas the investors expects the future interest rate to be stable then to make a gain out of this the investor can take buy long dated securities. From the investor’s point of view the long term securities are undervalued as their price reflects expectations about a higher market interest rate. Gains can be made from such strategies if an investor can forecast more accurately than the market on a consistent basis (Madura, 2008, p.61). Shape of yield curve and future interest rate By scrutinising the shape of the yield curve an investor can get an idea about the interest rate in the future and level of economic activity. The yield curve has three main shapes upward sloping, downward sloping and flat. An upward sloping yield curve suggests that the short term interest rates are expected to be higher than the current levels. A steep yield curve implies that the interest rates will rise considerably in the future. With the extension in maturity the investors ask for a higher yield if they anticipate fast economic growth owing to the risks associated with high inflation and interest rates. A flat yield curve signals a slowdown in the economy. The yield curve flattens when the interest rates are raised by the Federal Reserve in order to restraint a fast growing economy; hence the rise in the short term yields reflects the raise in the interest rate and interest rates for the long term fall on the anticipations of moderate inflation. An inverted yield curve implies that the short term bond yields are more than the long term bonds. This suggests that the investors expect a decline in the future interest rates (Baruch College, 2004). Shape of Yield curve and future inflation As per the Expectations theory if there is an anticipation that the annual inflation rate will decline then the yield curve becomes downward sloping and vice versa. An upward sloping yield curve implies that the interest rates are expected to rise in the future. This has an impact on the rate of inflation. The interest rate is the sum of risk free rate and an adjustment for the inflation factor. To estimate the expected rate of inflation one can deduct the risk free rate from the nominal interest rate (Besley, et al, 2007, p.205). The shape of the yield curve depends on the inflationary expectations. A rise in the rate of future tends to make the yield curve steep. Similarly a fall in the expected rate of inflation flattens the yield curve. If the market expects the rate of inflation to fall the yield curve becomes downward sloping; in such case interest rates on short term securities will be higher as compared to long term securities (Gamber & Colander, 2006, p.254). Part 3- Covered Interest parity Covered interest parity states that the future exchange rates adjust so as to equalise the interest rates in the future between two different countries. In other words there exists an equilibrium relationship between interest rate, spot exchange rate and forward exchange rate of two countries. The covered interest parity (CIP) states that there should not be any interest differential between two identical assets, differing only in terms of currency. Any deviations from CIP present risk less opportunities for arbitrage and signify market inefficiency. The relationships derived from CIP are taken as identities in ‘international macroeconomic theory’ (Centre for Economic Policy Research, n.d.). Assuming that the interest rate parity holds good the relationship between pounds sterling and US dollar can be stated as- Source: (Pietersz-b, 2011). r? is the interest rate in UK r$ is the interest rate in US ?/$f is the forward rate of pound per dollar ?/$s is the spot rate of pound per dollar Example- Suppose an investor wants to deposit A$100 for 3 months. The return generated if the amount is invested in Australia would be A$100(1+ia) where ia is the 3 month interest rate in Australia. Alternatively the amount can be deposited in Singapore. For this the amount has to be converted into Singapore dollars. This would yield “A$100* Spot(S$/ A$)*(1+rs)” where ‘rs’ is the interest rate for 3 months in Singapore. This amount is then converted into Australian dollars resulting in an inflow of “A$100*Spot(S$/ A$)*(1+rs)/Forward(S$/A$)”. Under covered interest parity the amount realised under both the strategies will be same. Like if the interest rate is 7% in Singapore whereas the interest rate is 4% in Singapore, then as per CIP there will be a forward premium of 3% on Australian dollar. This means that forward rate of Australian dollar will be 3% higher than the spot value i.e. the value of dollar will appreciate over the time period of deposit by 3%. This would make investing in Singapore dollars unattractive (Ingram, 2007). Uncovered interest rate arbitrage The interest rate parity states that the interest rate difference between two nations is equal to the anticipated change in the exchange rates of the currencies of the two countries in the future. Id this condition does not hold good it gives rise to an arbitrage opportunity. The uncovered interest arbitrage is similar to the covered interest arbitrage. However the difference in the two strategies is that in the former the currency risk is not covered i.e. it is not hedged. For this reason it cannot be treated as a “true arbitrage strategy” (Pietersz-a, 2011). The uncovered interest arbitrage is a strategy that helps in making profits by taking advantage of the difference in the interest rates of two countries by focusing on the anticipated change in the exchange rates of the currencies of the two countries. This is referred as ‘uncovered’ as the long position initiated in the currency purchased is left open giving rise to the risk of exchange rate fluctuations. Therefore the uncovered interest arbitrage requires a forecast of the expected rates. Suppose an uncovered interest arbitrage involves taking a short position in currency ‘x’ and a long position in currency ‘y’. At time period ‘t’ an amount of ‘K’ of ‘x’ is borrowed for an interval between t and t+n at an interest of say ‘ix’. The amount borrowed in ‘x’ is converted into currency ‘y’ at the spot exchange rate of ‘(x/y)t’ giving an amount of K/(x/y)t of ‘y’. This amount is invested at ‘iy’ for the period between ‘t’ and ‘t+n’ . As on ‘t+n’ the amount obtained in terms of currency ‘y’ is ‘K/(x/y)t*(1+iy)’. This amount is known beforehand at the time period ‘t’ as both ‘iy’ and ‘(x/y)t’ is known at this time. However the value of this amount at the future date is not known as it depends on the expected exchange rate between currencies x and y at time period ‘t+n’. i.e. ‘(x/y)t+n’. The expected value of the principal and interest at time ‘t+n’ is ‘K/(x/y)t*(1+iy)*E(x/y)t+n’. Also on the amount of ‘K’ borrowed for ‘t+n” an amount has to be paid as interest i.e. the amount to be repaid is ‘K(1+ix). Therefore the anticipated net profit is- = [K/(x/y)t*(1+iy)*E(x/y)t+n]- K(1+ix) This strategy will be profitable only if the anticipated change in the exchange rate is more than the difference in the interest rate (Moosa, 2000, p.37) Suppose the interest rate in Country A is higher as compared to country B. In this situation there will be an uncovered interest arbitrage if the expected rate of depreciation in the currency of A is less than the interest rate differential of the two countries (Pietersz, 2011). Purchasing Power parity The purchase power parity (PPP) theory explains the relationship between exchange rate and inflation. There two forms of PPP- Absolute form of PPP- This form is derived on the premise that in the absence of international barriers the consumers will shift to a country where the prices are low. It states that the price of a similar “basket of products” must be the same in two countries when measured in terms of a common currency. If there is a discrepancy then the demand will shift that will bring about convergence in prices. Suppose the price of a “basket of products” is lower in UK as compared to US; the demand for this group of products will decline in US and increase in UK. In the due course there will be an effect on the prices charged in both the countries and/ or there will be an adjustment in the exchange rates. Due to this the prices of the “basket of products” will be the same when measured in terms of a common currency. However in the presence of huge transportation costs there may not be any shift in the demand as a result of which the price discrepancy would continue. Relative form of PPP- This form of PPP takes an account of market imperfections like quotas, costs of transportation, tariff. It acknowledges that on account of market imperfections the prices of similar group of products may not be similar when measured in terms of a common currency. However this theory states that any change in the price rate of the group of products will be the same when measured in terms of a common currency with the other costs like transportation remaining unchanged. Suppose the inflation rate is 9% in US and 5% in UK. Then as per the PPP theory there will be an appreciation in the pound sterling by nearly 4% i.e. the difference in the rate of inflation. This means that an adjustment in the exchange rate will offset any differences in the rate of inflation of the two countries. Therefore the consumers will be indifferent between the goods of the two countries (Madura, 2008, p.214). Reference Baruch College. 2004. Yield Curve Basics. Yield Curve. Available at: http://faculty.baruch.cuny.edu/ryao/fin3710/PIMCO_YIELD_CURVE_PRIMER.pdf [Accessed on February 23, 2011]. Besley, S. Brigham, F.E. 2007. Essentials of managerial finance. Cengage Learning. Centre for Economic Policy Research. No Date. Covered Interest Parity. Bulletin. Available at: http://www.cepr.org/pubs/bulletin/dps/dp236.htm [Accessed on February 23, 2011]. Elton, J. E. Gruber, J.M. Brown, J.S. Goetzmann, N.W. 2009. Modern Portfolio Theory and Investment Analysis. John Wiley and Sons. Gamber, E. Colander, C.D. 2006. Macroeconomics. Pearson South Africa. Ingram, M. 2007. Covered interest parity. Available at: http://wiki.uiowa.edu/display/06e169/Covered+interest+parity [Accessed on February 23, 2011]. Investopedia. 2010. What Does Capital Asset Pricing Model - CAPM Mean?. Capital Asset Pricing Model – CAPM. Available at: http://www.investopedia.com/terms/c/capm.asp [Accessed on February 23, 2011]. Kurschner, M. 2008. Limitations of the Capital Asset Pricing Model (CAPM): Criticism and New Developments. GRIN Verlag. Madura, J. 2008. Financial markets and institutions. Cengage Learning. Madura, J. 2008. International Financial Management. Cengage Learning. Moosa, A.I. 2000. Exchange rate forecasting: techniques and applications. Palgrave Macmillan. Palmiter, R.A. 2003. Critical assumptions of CAPM. Available at: http://www.wfu.edu/~palmitar/Law&Valuation/chapter%202/2-5-3.htm [Accessed on February 23, 2011]. Pietersz, G-a. 2011. Uncovered interest arbitrage. Available at: http://moneyterms.co.uk/uncovered-interest-arbitrage/ [Accessed on February 23, 2011]. Pietersz, G-b, 2011. Covered interest rate parity. Available at: http://moneyterms.co.uk/interest-rate-parity/ [Accessed on February 23, 2011]. Sigman, K. 2005. Capital Asset Pricing Model (CAPM). Available at: http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf [Accessed on February 23, 2011]. Read More