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Capital Asset Pricing Model Report (Assessment)

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Role of Capital Asset Pricing Model (CAPM) in modern portfolio management

In modern industrial economies, business owners aim to maximize on their returns while the managers want to minimize risk on their hands. This provides a typically very different opinion between the management and ownership about risk and returns.

With this issue, most of the large companies in the world especially in the United States have established their capital budgeting process in the Capital Asset Pricing Model. This theoretical model was formulated thirty years ago by Sharpe (1994) and Linter (1965).

CAPM assist businesses managers by providing a practical method to learn about how investors value the risk of potential investment opportunities, that is, value of decisions to be taken (Mehrling, 2005).

CAPM helps to show how to ascertain the risk of the cash flow from an investment venture, ascertain the venture’s cost of capital and the expected rate of return which an investor expects if they invest in a certain project. In addition, it shows the opportunity cost of not investing in a certain project.

One of the most outstanding characteristics of Capital Asset Pricing Model is that it does not assume any particular form of the trader’s utility functions apart from some extent of risk aversion which, nevertheless can be defined without resorting to a utility function.

Despite the drawbacks, the capital asset pricing model still offers a more comprehensive view of long-term swap in return and risk in the pricing of financial securities and assets. The CAPM can provide an adequate steer for the average long-term security owner.

It has certain principles that prove useful: CAPM assumes diversity of assets since there is no tradeoff in unsystematic risk portfolio. Also, an investor should hold onto his or her securities for a long term regardless of the time factor in order gain the expected returns.

In addition, an investor should take on more systematic risk so as to achieve a higher return on investment, the larger the portfolio an investor has that are receptive to the changes in market environment, the more average return the portfolio will achieve.

CAPM suggests that in the short term, or more complex investing, other models have been established. However, unless the model is established on market inefficiencies, no flow of information, or other assumptions of CAPM, the model is assumed to hold the principles of CAPM.

CAPM as a theoretical perspective has been put to test in several occasions. Earlier CAPM empirical tests done by Fama and French in 1992, show that the model was empirically applicable except that the Security Market Line intercept was approximated to be about 4 to 5 percent more than the risk-free rate, although such an event is concurrent with the CAPM model in cases where money cannot actually be borrowed at the risk-free rate.

More current tests of the CAPM display that there are many noticeable drawbacks of the stern analysis of the model. For example cyclical fluctuations, such as unexpected high returns for some companies during the month of February and varying returns on Mondays and Fridays from that of Tuesdays to Thursdays.

However, critics have said that security returns are highly closely correlated to the realizable value and the total inconsistency of the security, rather than a beta coefficient found by using a market index (Fama & French, 1992).

CAPM is used to highlight the variations in risk premium across financial assets and securities. Companies or investors are able to explain the trend taken by a certain asset in the market by using CAPM and hence influence their decision criteria towards a certain security.

According to CAPM these variations are as a result of variations in the risk level of the returns on the securities. CAPM proposes for the use of beta to measure securities risk level and that the risk rate per unit of risk level is the same in each asset.

According to CAPM, the cost of capital is a perfect linear equation of the rate of return on a risk free financial security and the beta of the project being assessed.

With this in mind, an analyst who has an estimate of the beta value of a potential project can apply the CAPM to ascertain the cost of capital for the asset. CAPM can also be used in explaining cross-sectional variation in the returns of different assets.

Identifying mispriced securities

In the case of mispriced securities it is advisable to use the Arbitrage Pricing Theory over the Capital Asset Pricing Model. In the APT concept, arbitrage occurs when trading in two securities and one is mispriced, that is, underpriced or overpriced.

The arbitrager buys securities that are underpriced and disposes of assets that are overpriced and hence makes high returns without assuming any additional risk on his investment.

For Jeffrey Burner to handle arbitrage trading, the value of a security should equate the total net present value of all cash flows discounted at the Arbitrage Pricing Theory rate.

Where the expected return of the security is a linear equation of numerous factors the sensitivity to variations in every factor is shown by a factor-specific beta coefficient (Breen & Korajczyk, 1993).

I would use the CAPM method to identify mispriced securities. Since we deal with a portfolio of assets held together, it must be noted that the portfolio exposes the investor to all the macroeconomic factors as the mispriced security. In CAPM, the factor specific beta is calculated through a linear regression of past information on returns on the factor under consideration.

Just like CAPM, the Arbitrage Pricing Theory holds that rather few factors create relationships and that the expected return on a security of an asset class ought to be as a result of its exposure to those factors that are less constant. APT stops at the expected return an investor gets from the exposure to factor three which cannot be ascertained.

CAPM argues that if factor three does not perform well in the markets, the expected return for taking the risk to that factor must be high enough. In cases where the factor is a random one and does not correlate or performance of the security is bad, the return from the security should be expected to be zero.

In a way the Arbitrage Pricing Theory is more comprehensive since it makes some strong arguments about the return generating process of a security although it fails since it does not evaluate the expected return on the three factors.

CAPM takes into consideration the investor’s risk and expected returns preferences to determine the security’s or asset’s prices in the market. The CAPM does not specify the number of factors to be put into consideration but can take any number of factors that the security may have thus; expected return of a financial asset is associated with the extent of exposure to all the factors (Burmeister, 1986).

Sharpe argues that an investor can not actually build a portfolio by using only the Arbitrage Pricing Model. An investor ought to pinpoint the factors and the expected returns to accrue from the exposure to each factor. Pro APT scholars have argued that one should approximate the expected returns empirically.

But Sharpe sees it as very risky since historic average returns can vary monumentally from the investor’s expectations. An analyst needs a factor model to decrease the dimensions.

The APT assumes that returns are determined by a factor function, and does not make any strong arguments besides the model; an analyst cannot determine empirically the expected returns correlated with the functions. CAPM provides a more consistent method of ascertaining the expected returns.

CAPM is not derived from the Efficient Market Hypothesis and is independent of the existence and functioning of the EMH. The CAPM takes into assumption the efficiency of portfolios making very distinct from EMH.

Nevertheless market based analyses indicate the similarity between EMH and the CAPM. Thus CAPM does not need maintenance in analysis unlike the APT where the raw stock is usually dependent on the variable.

Nevertheless, CAPM has been assumed to be a basis of the ATP since market securities index indicate a very specific factor model of asset values in cases where the beta factor is against variations in prices in the market.

In addition, the APT is considered as a ‘supply side’ function, since the model’s betas replicate the sensitivity of the fundamental asset to the market factors. Hence, factor variations would lead to a structural adjustment in the security’s expected returns, or in the case of assets, in company’s sustainability.

The market trends have show that using the capital pricing model is normally used as a “demand side” model. In the long run, even if CAPMS outcome is equal to ATP outcome, these results due to maximization of every investor’s utility function in addition to the resulting market balance (Black, Michael & Myron, 1972).

Although Arbitrage Pricing Model and Capital Asset Pricing Model are more or less similar to each other, I consider CAPM more articulate. The main difference between CAPM and APT is that, CAPM is less restraining in its assumptions, it allows for a narration model of asset returns.

APT fails in that it an investor will hold a distinct portfolio with its own specific beta values unlike CAPM which aggregates the market portfolio. CAPM takes into account the time factor and allows for undiversifiable risks that are as a result of the market forces.

In APT, the portfolio’s is exposed to the same risk in all of the external market factors as the mispriced security. In a CAPM model an arbitrager cannot make an arbitrage profit by creating a portfolio whose beta coefficient is equal to that of the mispriced asset. Also CAPM clearly distinguishes systematic and unsystematic risk (Chen, 1983).

Reference List

Black, Fischer., Michael C. Jensen, and Myron Scholes (1972). The Capital Asset Pricing Model: Some Empirical Tests, pp. 79-121 in M. Jensen ed., Studies in the Theory of Capital Markets. New York: Praeger Publishers.

Breen,William J., and Korajczyk, Robert A. (1993). On selection biases in book-to-market based tests of asset pricing models. Working Paper 167. Northwestern University.

Burmeister, Edwin and Wall, Kent D. (1986). “The arbitrage pricing theory and macroeconomic factor measures”. Financial Review 21 (1): 1–20. Fabozzi, Frank J., ed. Handbook of Portfolio Management. New York: McGraw-Hill, 1998.

Chen, N. F.; Ingersoll, E. (1983). “Exact Pricing in Linear Factor Models with Finitely Many Assets: A Note”. Journal of Finance 38 (3): 985–988.

Fama, Eugene F., and French, Kenneth R. (1992). The cross-section of expected stock returns. Journal of Finance 47 (June): 427–65.

Lintner, J. (1965). “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics, no. 47.

Mehrling, Perry (2005). Fischer Black and the Revolutionary Idea of Finance. Hoboken: John Wiley & Sons, Inc.

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