Mn3366K Strategic Finance - Capital Assessment Answers

 

In the formula the risk free rate determines the value of the money through the time and also allots the compensation to the investors on account of investing the money in any kind of shares or the mutual funds over the period of time. The risk free rate is customarily yield on the government bonds like U.S. Treasuries. The second half of the CAPM formula outlines the risk and the compensation amount can be calculated which is required by the investor so that he can utilise the money for the additional risk(Fard and Falah, 2015). The risk measure factor basically does a comparison of assets of the market against the market over time and market premium.

 

                                                                                                          (Source: Corporate Finance, 2017)

The market premium is basically determined by the (Rm-Rf). Rm – Rf showcases the difference between the return of the market and the risk free rate of return. The beta feature in this formula reflects the risk factor of an asset with the total risk of the market and the volatile nature of the asset can also be assessed easily (Bao, Diks and Li, 2018). The main purpose of the formula is to explicitly determine the correlation between the two above factors.

For example the risk free rate of return is 3%, and the beta value of the stock is 3. The expected market return over the period is 12%, therefore the market risk premium is (12-3) which is 9% after getting the difference of the risk free rate of return and the expected market return.

If all the figures are plugged in than the expected return of the stock is 0.29 or 29%

0.03 + [3*(0.12-0.03)]

There are certain assumptions of the CAPM which are as follows. The CAPM model was extended by Markowitz which was initially introduced. He put forward his argument that the investors are risk taker investors. The investment made by the investors is basically the choice between a portfolio by having a trade-off between the risk and the return for the one investment period(Fernandez, 2015). The investors choose those portfolios that present the low variance and provide the specific expected return and therefore the model is known as Markowitz model.

                                                                                                           (Source: Accounting Explained, 2017)

Figure 1 says that the CAPM with the amalgamation of the effective frontier and the extended line for the risk free return point on the y axis. With the help of the standard deviation the risk of the portfolio can be assessed and the same has been shown on the horizontal axis.

The inequality of borrowing and the rates determined for the purpose of lending and the same were outlined by the Friend and Blume 1970 (Campbell, Giglio,  Polk and Turley, 2018). The plausible cause of the difference between the risk and the return featureof New York Stock Exchange Securities and the assumptions of the Capital asset pricing model is the inequality between the above two factors. The argument by the authors is about the inequality between the borrowing from the investor and the lending rates will ultimately result in a risk return trade off.

The second logic of the assumption of the riskless borrowing and the lending becomes unrealistic. Black who was born in the year 1972 developed a CAPM model under which he did not include the above assumption. His idea of setting up the portfolio is that the mean variance efficient portfolio can be obtained with the help of the short selling of the risky assets(Fan, Furger and Xiu, 2016).

Again the next assumption of the CAPM model was the divisibility of all the financial assets fully where the investors have the choice to buy and sell as much more or less securities they wanted to. Moreover the time period of the selling of the securities was also not fixed and the same was sold at the market price.Shahzad, S.J.H., Khalid, S. and Ameer, S., (2016)

The major difference between the model of the Sharpe and the linter against the Black was that in case of the Sharpe-Linter the return was the return is free from the interest but in case of the Black the return allows the premium and the beta of the market to be positive. Yet the assumptions made by the Black were also unrealistic in nature. The efficient portfolio does not exist because there is no risky asset and no unrestricted shorts selling of the risky asset and therefore there is lack of relationship between the market beta and CAPM. Therefore the CAPM model is based on the different assumptions(Mazzola and Gerace, 2015).

1	The expected returns on the underlying assets are linearly related to their respective betas
2	The premium beta tends to be positive under which the expected return on the market exceeds the expected return
3	Assets are unrelated with the expected return of the market portfolio

                                                                                                                         (Source: Prezi2017)

The above diagram depicts the situation in two different ways. The Capital market line and the security market line. The capital market line described the trade-off between the rate of the return and the risk of the efficient and the potential portfolios. Under the CML the investors choose the position on the CML in the equilibrium by purchasing or lending at the risk free rate(Anwar and Kumar, 2018). This is done because it maximises the return for the given level of the risk, whereas the SML is the diagramatic representation of the CAPM model. The diagram above represents the relationship between the beta factor and the expected rate of the return which is linked with the particular security. If the expected return of the security is plotted above the SML, it tends to be undervalues and vice versa given the risk return trade off.

Although the CAPM has been one of the most the frequently used model, but with the help of the empirical studies there are some demerits and the cons in the model in relation to the risk which is measured by the Beta and the return on the asset. Shaken in the year 1982, outlined his argument on the fact that CAPM model is not truly testable. According to different investors in the year after 1982, the CAPM model was found as non-testable unless the market portfolios of all the assets are used in the empirical test(Bendob, Chikhi and Bennaceur, 2017).

The CAPM has been criticized in many researches and the observations because of the major assumptions which rely on the two features which are risk free borrowing and lending. Furthermore, according to the Fama and French there are specific industries for which the CAPM model did not work at all. The estimates for the cost of equity capital are covered with errors of more than 3.5% per year. The estimates are not accurate for individual firms and the projects. There are certain unrealistic assumptions, because of which the CAPM fails due to the factors for example one period investment, unrestricted risk free borrowing and lending (Xiao, Faff, Gharghori and Min, 2017)

There are several extensions to the CAPM model from the one it was introduced. The journey of the CAPM through different versions is states below. Fama and French propose the third model named as the three factor model. In their model there was an addition of the two factors such which enhanced the CAPM model in a better manner. The critical factor that helps to run the three factor model is the size and the market equity. However, at times the market risk is also considered. Empirically, they provide evidence on the covariance. The covariance of the small firms is literally high and in case of the large firms the case is reverse. Further, the stocks are measured by the book to the market ratio (Ready Ratios, 2016).

Merton introduced the ICAPM model in the year 1973. Merton’s intertemporal capital asset pricing model is an extension of the CAPM. The ICAPM has a different version of the assumption about the objectives of the investor. Under this CAPM model, investors are concerned only about the wealth which is obtained by the portfolio at the end of the current year. But under the ICAPM model the renewed version of the CAPM model the investors and the stakeholders care about not only the end of the period pay off but also the future possibilities and the opportunities to consume or invest this pay off. The investors consider the factor of how their wealth will fluctuate with future variables and the income, the prices of the consumption of the goods and the nature of the portfolio opportunities (Prezi. 2017).

Lucas who introduced the model in the year 1978 extended the traditional CAPM into the CCAPM commonly known as the Consumption Capital Asset Pricing Model. This model describes the direct relationship between the consumption and the stock returns and therefore it relies upon the aggregate consumption in order to have an analysis and the understanding of the future asset prices unlike the traditional CAPM Model which links the market’s portfolio return(Finance Formulas, 2016).

The CAPM model has the numerous advantages over the other methods of calculating the return and the advantages will surely explain why it has been popular for more than 40 years.The best feature of the CAPM model is that it considers only the systematic risk and reflects the reality in which major number of the investors has a wide range of the portfolios from which the unsystematic risk has been totally eliminated and eradicated.

The CAPM model is the theoretical equation between the required rate of return and the systematic risk which has been forwarded for the purpose of the future empirical research and the testing procedures(Accounting Explained, 2017).

In terms of the calculation of the cost of the equity the CAPM model is considered better than the Dividend Growth Model as it explicitly considers the platform of the systematic risk in association with the entire stock market.

Moreover many investors argue that this model is superior to the Wacc model in providing the discount rates for the appraisal and the appreciation of the investment in the near future.

There are certain problems in applying the CAPM model which have been outlined below.

The first assumption of the model is to assume that the risk factor has the predictable relationship with respect to the return. The major issue arise when the volatility of the market is set at 1 and the higher volatility of the Beta id larger than one. For example if the value of the Beta is 3 the security price shifts three times as far as the market and if the value of the beta is 0.75 than the price moves only 3/4^th (Wall Street oasis, 2016).

Secondly the model suggests that the variance of the return is the sole measurement of the risk. But when compared to the other models, in case of the financial statements the variance is not the only factor, rather it is considered as the probability of the losing and moreover it is asymmetric in nature.

According to this model the all the investors whether the active or the potential the CAPM model comes up with the dubious assumption that market of the securities is made up of only one kind of the investors and every investor requires the same information and analyses the securities in the same manner. The assumption of the homogeneity is the biggest rival of the CAPM model itself(Valueadder.com, 2017).

The model also comes up with another kind of the problem that both the active and potential shareholders will prefer the lower risk but in reality the situation is totally opposite and the problem occurs in applying the CAPM model(Lai and Stohs, 2015).

The conclusion says that the first angel revealed the ex-ante perspective and suggested the similar yields of the similar amounts of the risk being priced and on the other hand the second angle was the so-called ex post which revealed that the ex-ante price of the total risk is a function of the revised ex post price. These assumptions are not supportive to the paradigm. It follows directly from the CAOM;s own assumption that if in the situation of the equilibrium the investors price only the non-diversifiable risks then the fair ex ante price for the total risk of the asset shall be eventually higher. Therefore from the above essay in my opinion though the model started to establish itself around 40 years ago there are certain critiques and the problems in applying the CAPM model correctly to determine the rate of return. Hence, the investors may consider other models as well to get a variance of the model and the comparative analysis so that they can invest accordingly.

References

Accounting Explained, (2017) what is Capital Asset Pricing Model (CAPM)? [Online] Available from https://accountingexplained.com/capital/equity-valuation/capital-asset-pricing-model [Accessed on 4th September 2018]

Anwar, M. and Kumar, S., (2018) Sectoral Robustness of Asset Pricing Models: Evidence from the Indian Capital Market. Indian Journal of Commerce and Management Studies, 9(2), pp.42-50.

Bao, T., Diks, C. and Li, H., (2018) A generalized CAPM model with asymmetric power distributed errors with an application to portfolio construction. Economic Modelling, 68, pp.611-621.

Barberis, N., Greenwood, R., Jin, L. and Shleifer, A., (2015) X-CAPM: An extrapolative capital asset pricing model. Journal of financial economics, 115(1), pp.1-24.

Bendob, A., Chikhi, M. and Bennaceur, F., (2017) Testing the CAPM-GARCH Models in the GCC-Wide Equity Sectors. Asian Journal of Economic Modelling, 5(4), pp.413-430.

Campbell, J.Y., Giglio, S., Polk, C. and Turley, R., (2018) Anintertemporal CAPM with stochastic volatility. Journal of Financial Economics, 128(2), pp.207-233.

Fan, J., Furger, A. and Xiu, D., (2016) Incorporating global industrial classification standard into portfolio allocation: A simple factor-based large covariance matrix estimator with high-frequency data. Journal of Business & Economic Statistics, 34(4), pp.489-503.

Fard, H.V. and Falah, A.B., (2015) A New Modified CAPM Model: The Two Beta CAPM. Jurnal UMP Social Sciences and Technology Management Vol, 3(1).

Fernandez, P., (2015) CAPM: an absurd model. Business Valuation Review, 34(1), pp.4-23.

Finance Formulas, (2016) Capital Asset Pricing Model (CAPM) [Online] Available from https://financeformulas.net/Capital-Asset-Pricing-Model.html [Accessed on 4th September 2018]

Lai, T.Y. and Stohs, M.H., (2015) Yes, CAPM is dead. International Journal of Business, 20(2), p.144.

Mazzola, P. and Gerace, D., (2015). A comparison between a dynamic and static approach to asset management using CAPM models on the Australian securities market. Australasian Accounting, Business and Finance Journal, 9(2), pp.43-58.

Prat, R., (2016) Five Objections Against Using a Size Premium When Estimating the Required Return of Capital with the Capital Asset Pricing Model.

Prezi. D, (2017) CAPM: Assumptions and Limitations | Securities | Financial Economics [Online] Available from https://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-limitations-securities-financial-economics/29904 [Accessed on 4th September 2018]

Ready Ratios, (2016) Capital Asset Pricing Model (CAPM) [Online] Available from https://www.readyratios.com/reference/analysis/capital_asset_pricing_model_capm.html [Accessed on 4th September 2018]

Shahzad, S.J.H., Khalid, S. and Ameer, S., (2016) CAPM estimates: Can data frequency and time period lend a hand?. International Journal of Financial Engineering, 3(02), p.1650018.

Sumalatha, V. and Santhi, R., (2017) Deployment of Classification Approach for Sensing Stress of Juvenile Using CAPM Model.

Valueadder.com, (2017) How Capital Asset Pricing Model (CAPM) works [Online] Available from https://www.valuadder.com/glossary/capital-asset-pricing-model.html [Accessed on 4th September 2018]

Wall Street oasis, (2016) Definition of Capital Asset Pricing Model (CAPM) [Online] Available from https://www.wallstreetoasis.com/finance-dictionary/what-is-the-capital-asset-pricing-model-capm [Accessed on 4th September 2018]

Xiao, Y., Faff, R., Gharghori, P. and Min, B.K., (2017) The Financial Performance of Socially Responsible Investments: Insights from the Intertemporal CAPM. Journal of Business Ethics, 146(2), pp.353-364.