The Capital Asset Pricing Model

Question: What is the Capital Asset Pricing Model? Explain. Answer: A portfolio may be defined as a bundle of securities. The whole purpose of modern Portfolio Theory is to explain the benefit of diversification i.e. risk reduction effect of a portfolio. We should not invest our wealth in a single stock. We should invest in a portfolio. Whenever, we combine two or more assets in a portfolio, risk reduction depends upon co-relation. As we move further into the portfolio theory, we will find that- lower the co-relation, greater is the risk reduction. In this theory, we assume that the investors are rational which means that investor love higher return and they hate risk. Investor would therefore like to choose a stock or portfolio with a high expected return and a low risk.(Fama, 2004) However, if the markets are efficient, risk and return go hand in hand. There exists a direct relationship in between risk and return i.e. the more is the amount of return involved, the higher is the risk associated with that stock or portfolio and vice-versa. The direct relationship between the return and risk is depicted in the diagram below, x-axis denotes risk whereas y-axis denotes the amount of expected return, it can be seen in the diagram as the amount of risk is increasing, the amount of expected return is also increasing accordingly.(Bernstein, 1974) The following table also helps to determine the risk and return relationship: Particulars Expected return Risk Stock A 22% 6% Stock B 25% 7% Stock C 28% 8% Stock D 31% 9% As per the Capital Asset Pricing Model, the only relevant measure of stocks risk is Beta. Beta helps to measure the volatility of the stock i.e. it shows the degree of change in the price of the stock (up and down) with the change in the stock market. For example- A stock with a beta of 2.5 would rise by 50% if market rose by 20% and will fall by 50%, if market fell by 20%. Beta helps to therefore determine the relationship in between the risk and the expected return. If the stock price moves exactly in line with the market, then beta of that stock is equal to 1. Capital Asset Pricing Model provides a good account for pricing a firms debt or equity through the use of Beta. Portfolio Beta is a weighted average of the Betas of the stock in the portfolio. Weight of each stock is taken according to its current market value. Fund Managers normally engage in Market timing in the following manner: If Market is expected to fall, fund managers reduces the Beta of its portfolio by shifting from high Beta stock to low Beta stock or to risk free stocks. If Market is expected to rise, fund managers increase the Beta of its portfolio by shifting from low Beta stock to high Beta stock. The central theme of Capital Asset Pricing Model is that the risk can be decomposed into systematic risk and unsystematic risk. Unsystematic risk is diversifiable i.e. it can be killed by diversification. So the only relevant risk is systematic risk which is captured by Beta.(Basu, 1983) Systematic risk is that part of the variance which arises because of the economy wide factors; hence it is also called as market risk.(Mclure, 2014) Following are the assumptions on which The Capital Asset Pricing Model depends on which also forms a part of the fundamental feature of this model, the assumptions are as follows: Category 1: Investor Related Investor are rational Investor have uniform single period investment horizon Investor have homogenous expectation Category 2: Risk Free Rate Related There is unlimited borrowing or lending opportunity at risk free rate. Category 3: Market Related Markets are perfectly competitive i.e. large number of investors, no taxes, no transaction cost, no restriction on short selling and fully divisible securities are available. Under the Capital Asset Pricing Model world, investor invest in the most diversified portfolio i.e. market portfolio and combine that with risk free rate borrowing or lending. In short, all investors lie along the Capital market Line and they enjoy the highest SHARPE Ratio.(Ross, 2012) Asset prices under the Capital Asset Pricing Model are determined by using discounted cash flows, since cash flows are uncertain the required return is risk adjusted return. Systematic risk is measured in terms of Beta i.e. sensitivity with respect to market.(Jr, 1982) A portfolio may be defined as a bundle of securities. The whole purpose of modern Portfolio Theory is to explain the benefit of diversification i.e. risk reduction effect of a portfolio. We should not invest our wealth in a single stock. We should invest in a portfolio. Whenever, we combine two or more assets in a portfolio, risk reduction depends upon co-relation. As we move further into the portfolio theory, we will find that- lower the co-relation, greater is the risk reduction Under the Capital Asset Pricing Model, Expected Return = Risk free rate + (Market return rate Risk free rate)* Beta. Capital Asset Pricing Model is of relevance to the corporate managers because of the following reasons which are as follows:(Perold, 2004) Capital Asset Pricing Model considers only systematic risk thus reflects the reality in which most of the investors have their portfolios diversified, from which there is a total elimination of the unsystematic risk. Capital Asset Pricing Model provides a better approach than the WACC in providing the use of discount rate for the purpose of the appraisal of investment. Capital Asset Pricing Model helps to provide a theoretical relationship in between the return and systematic risk. Capital Asset Pricing Model is a better method for calculation of cost of equity rather than dividend growth model. The academic community is turning away from the Capital Asset pricing Model because of the following reasons which are as follows: Calculation of Beta is not so easy under this model. It is difficult to calculate the specific-project discount rate. Short-term government debt yield is not fixed; it changes with the change in economic circumstances. Category 1: Investor Related Investor are rational Investor have uniform single period investment horizon Investor have homogenous expectation Conclusion The relevance of CAPM thus can be understood with the help of the concept of the decisions of the corporate managers that are taken on the basis of the various risk return concepts and the corporate mangers use rate of return and cost of capital into consideration for the same and the decision is based on the same. This theory helps to find the relevant rates of return for the projects and other fianc related areas.(French, 2004) References Banz, R. (1981). The Relationship between Return and Market Value of Common Stocks. Journal of Financial Economics , 3-18. Basu, S. (1983). The Relationship between Earnings Yield, Market Value and the Return for. Journal of Financial Economics , 126-156. Bernstein, P. L. (1974). Portfolio Management. The Journal of Portfolio Management , 1-3. Fama, E. F. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives , 25-46. French, E. F. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives , 25-46. Jr, D. W. (1982). Does the Capital Asset Pricing Model Work. Harvard Business Review , 1-1. Mclure, B. (2014). CApital Asset pricing Model. investopedia , 1-1. Perold, A. F. (2004). The Capital Asset Pricing Model. Journal of Economic Perspectives , 1-18. Ross, S. A. (2012). THE CAPITAL ASSET PRICING MODEL (CAPM), SHORT-SALE RESTRICTIONS AND RELATED ISSUES. The Journal of Finance , 1-4. Fama, Eugene F., and Kenneth R. French. 2004. "The Capital Asset Pricing Model: Theory and Evidence."Journal of Economic Perspectives, 18(3): 25-46.