Are Capital Asset Pricing Model Useful Finance Essay

The CAPM model has generally been attributed to William Sharpe, but John Lintner and Jan Mossin also made similar individual derivations in 1960s. As a result of the model is even known as Sharpe-Lintner-Mossin (SLM) capital asset pricing model. The CAPM explains the relationship that should exist between the securities expected return and their risk about security returns. It is a direct extension of the portfolio models developed by Markowitz and Sharpe. CAPM derives the relationship between required rate of returns and the systematic risk of individual securities and portfolios. The model explains how different securities or assets in the capital market are priced. The CAPM provides an explicit measure of the risk premium. The CAPM can be expressed as follows:

The portfolio that contains all the securities in the economy is called the market portfolio and it plays a crucial role in CAPM. The CAPM is the theoretical relationship that should hold for all securities and portfolios, both efficient and inefficient. The CAPM when plotted on a graph gives a line as depicted:

The graphical version of CAPM is also known as Security market line (SML). The SML represents the relationship between beta factor and the expected rate of return f a security. This is also called risk-free rate. In equilibrium, all securities and portfolios plots should lie on the CAPM line. Capital asset pricing model has the following implications:

Risk-return relationship for individual asset/securities.

Identification of under and overvalued assets traded.

Pricing of assets which have not yet traded in the market.

Effect of leverage on cost of equity (rate of return required by equity shareholder)

Capital budget decisions and cost of capital. (Source: Capital asset pricing model; Portfolio management from ICFAI publication page no.91)

The CAPM has a variety of applications. Capital asset pricing model used for decisions relating to portfolio evaluation, capital expenditure, financing etc. The CAPM determines the cost of capital for discounting of future cash flows. CAPM is even assist in risk implications of mergers and acquisitions, product mixes and many more. CAPM has been the most widely used method in finance. Since the 1990s the CAPM has been started to be used in the calculation of risk-adjusted discount rate which has been a major contribution for capital budgeting. Capital budgeting is a key input for any organization so as to know the cost of capital for which companies use CAPM as they need market risk premium for calculating cost of capital. At present all MBA courses teach CAPM so as to calculate cost of capital. However the classic method for capital budgeting is to take Net Present Value (NPV). (Source: Bierman, H.J., 1993, “Capital Budgeting:A Survey,” Financial Management 22, 24) Investors should be cautious when applying the model to estimate assets returns and to evaluate investment performance.

Empirical appraisal of CAPM

The CAPM was developed on the basis of a set of unrealistic assumptions as the assumptions are not correct in their entirety. The CAPM must be tested empirically and validated before it can be used with any real confidence. The empirical test should look for the key results first, the positive relationship between returns and systematic risk and should appear to be linear. Second, test should attempt to assess the importance of market and company specific risk. Third, whether research questions on CAPM is conceptually possible. AT last CAPM if valid will assist in financial decisions. However, when analysis of bond is done, they do not plot on the SML. (Source: 80 International Research Journal of Finance and Economics – Issue 4 (2006))Empirical analysis is done to evaluate the assets, their risk, analyze and to be placed in respective place. Then only hurdle rates can be calculated for the project to be undertaken. (Jagannathan and McGrattan [1995].

Limitations of CAPM

CAPM is a useful model in dealing with the risk. However, it suffers from many Limitations firstly; the calculation of beta factor is very tedious as lot of data is required. The beta factor can be found by examining the security’s historical returns relative to the return of the market portfolio. Further, the beta factor may or may not reflect the future variability of returns. The assumptions of CAPM are hypothetical and are impractical. For example, the assumption of borrowed and lending at the same rate is imaginary and not practical. In practice the borrowing rates are higher than the lending rates. Secondly the earlier tests showed positive relation between returns and betas. However, the relationship was not strong as predicted by CAPM. All empirical studies testing CAPM have a conceptual problem. CAPM is an ex-ante model; that is data on expected prices are taken to test CAPM. Unfortunately, in practice the researchers or analyst have to work with the actual past (ex-post) data which will put up bias in the empirical results. (Source: capital asset pricing model www.ezinearticles.com)Third; beta is used as a measure for the security’s future risk. However there is no future data or information is available with the investors to calculate the beta. Hence, these investors take the help of past data to estimate the future prices of shares and the market portfolio. Thus, investors estimate beta using the historical data. One cannot expect the beta factor to be constant over time. It must be updated frequently. And at the same time CAPM is unable to capture the risk just only with the help of beta. (Source: capital-asset-pricing-model, www. professional-edu.blogspot.com)Fourth; CAPM assumes that the returns on the investments are tax free. However in today’s life the assumption is wrong as investments are subject to capital gain taxes and further adding transaction costs. And the taxes depends on the amount of return higher the return higher the tax and lower the return and lower the tax. Fifth; The CAPM has the assumption that the transaction costs are zero but it is not as such. In the capital market there is transaction cost for every transaction done, some investments hover below or above line which is discouraged due the transaction costs. And many investments involve significant transaction costs such as acquiring a business or real estate. (Stambaugh, R. F. 1999. Predictive regressions. Journal of Financial Economics 54) Doubt began to arise when taking a close look at the assumptions and these are reinforced by the empirical tests. The model focuses on market rather than total risk is clearly a useful way of thinking about the riskiness of assets in general. We do not know precisely how t measure any of the inputs required to implement the CAPM. This input should be ex ante but we only have ex post info available. The estimates used in the CAPM are subject to large errors.

Debate

The CAPM has been attractive in measuring the risk and return relation since three decades. With the help of CAPM the rate of return on different securities can be compared by the investor. With the comparison of expected rate of return on different securities investors/firms can wisely decide to invest in portfolio so as to maximize the return with minimizing the risk. (Source: CAPM from Book Financial Management by I M Pandey. But unfortunately, the empirical record is too poor to validate the way it to be used. The models problems may be due to theoretical failing or the unrealistic assumptions and the difficulties faces in applying the valid model. The model has been 1959 and since decades concerns have been raised on the number of studies about the model. There has been no historical relationship between returns and the risk i.e. the betas. (Source: Fama and French 1992) The conclusion interpreted from the statistical findings. The data are noisy to invalidate the CAPM. (Source: Christensen and Mendelson [1992] and Black [1993]. Despite criticisms, the general reaction has been to focus on alternative asset pricing models. (Fama and French [1992]. The economist show lack of empirical support for the CAPM which may be due to inappropriateness of assumptions made to facilitate the empirical test. For example, the return on stock market indices is good proxy for return on market portfolio but do not capture all assets in the economy such as human capital. Beta calculated for diversified portfolios are more accurate than that of the individual securities as grouping shrink beta range and hence reduces statistical power.

To improve the empirical testing of CAPM numerous changes had been done in the past overcome the limitations or even to look for the subsequent alternate model to validate. At the same time the researchers and practitioners have began to look for multi-beta models that overcome the shortcomings of the CAPM. Fama and French (1992) and Fama and MacBeth (1973) use the same procedure but the results are totally different from each other. The former has no relation at one hand and the later has a positive relation between return and risk. Everyone is in a debate of whether to follow CAPM model or not? Where the companies even use CAPM for their capital budgeting process. But still some academic feels that those who choose the CAPM will actually not be getting worthless advice. (Source: Eugene F. Fama and Kenneth R. French, Journal of Finance, Vol. 47, 1992, 427-465)The model is often used for looking the performance of mutual funds and other portfolios. One of the big problem is forming portfolio by sorting stocks on the basis of price ratios but the average returns do not relate to market betas. ((Lakonishok, Shleifer and Vishny, 1994, Fama and French, 1996, 1998).) At NYSE, NASDAQ from 1963 to 2003 the average return on the book to market equity ratio portfolio rises monotonically from 10.1% p.a. to 16.7% for ten portfolios in U.S. securities but the positive relation between beta and return predicted by the model was absent. Whereas all NYSE stocks between 1931-1965 estimated that the results were consistent with the CAPM model. (Black, Jensen and Scholes 1972)

Conclusion

CAPM has been facing a lot of criticism in the recent times still it remains a useful tool for many i.e. for estimating the cost of capital, investment performance evaluation and efficient market event studies (Moyer et al 2001:204; Campbell et al 1997:183). In some of the recent empirical studies CAPM is said to be invalid. The CAPM is stated in terms of ex ante parameters, ex post tests cannot be accepted as an ultimate rejection of the CAPM and its parameters (Levy 1997:147). The CAPM should be judged on the basis of insights it provides into the risk/return relationship. Without the CAPM, the knowledge of the capital market and the market conditions would have been very limited (Karnosky 1993:56). Every three out of four CFOs use CAPM model to estimate the cost of capital. (Source: Graham and Harvey (2001). Corporate managers in U.S. confirmed in a survey the use of CAPM as a key tool for capital budgeting. Current MBA aspirant are taught to use CAPM for estimating cost of capital.

The CAPM should be continued with both individual tests and multi-factor models joint tests such as APT. Such testing will help understanding of the stock market pricing mechanism and the risk/return relationship. The capital asset pricing model has been employed in a wide variety of academic and institutional applications such as measuring portfolio performance, testing of market efficiency, identifying under and overvalued securities, capital budgeting etc. Apart the model have also been used in business by analyst, researcher’s and firms.

CAPM has been the basis for modern capital market theory since 30 years, but with the emergence of new equity markets around the world during the last few years, accumulating research has increasingly created doubt on the model’s ability due to many cases arising where the model is not able to explain the correct movement of assets return. Despite its limitations and shortcomings, the CAPM model is a popular tool in the investment analysis. The simplicity of the model towards description of the equilibrium has made it quite popular among the users even today. There are other factors i.e. taxes, inflation, liquidity, and market capitalization and price earnings ratios apart from beta which affect required returns What believed is CAPM have significantly contributed to the security pricing theory, but applied in practice has got some defects and for which an extended CAPM should be applied or have to look for a new better model which should not have any deficiencies. The CAPM model is for sure here to stay and attempts will continue to improve the model and to make it more useful.