The Capital Asset Pricing Model.(CAPM).
CAPM – CONCLUSIONSSummaryThis chapter has explored most aspects of the capital asset pricing model in the detail likely to be required in examination questions.
However, you may simply be required to explain the model in outline, and discuss its advantages and limitations. For this sort of question, you do not need to get bogged down in details. A suggested brief description goes as follows.
The CAPM shows how the minimum required return on a quoted security depends on its risk. For simplicity, various assumptions are made.
a) A perfect capital market;
b) Unrestricted borrowing or lending at the risk- free rate of interest
c) Uniformity of investor expectations
d) All forecasts are made in the context of one time period only.
From this it is deduced that all investors will hold a well- diversified portfolio of shares, known as the market portfolio, which is really a ‘slice’ of the whole stock market. Although the market portfolio is not really held by investors, in practice even a limited diversification will produce a portfolio which approximates its behavior, so it is a workable assumption.
The attractiveness of any individual security is therefore judged in relation to its effect when combined with the market portfolio.
A security whose returns are highly correlated with fluctuations in the market is said to have a high level of systematic risk. It does not have much risk – reducing potential on the investor’s portfolio and therefore a high return is expected of it. On the other hand, a security which has a low correlation with the market (low systematic risk )is valuable as a risk reducer and hence its
required return will be lower. The measure of the systematic risk of a security relative to that of the market portfolio is referred to as its beta factor.
The CAPM shows the linear relationship between the risk premium of the security and the risk premium of the market portfolio.
Risk premium of share = market risk premium
The same formula can be applied to computing the minimum required return of a capital investment project carried out by a company, because the company is just a vehicle for the shareholders who will view the project as an addition to the market portfolio.
In practice many of the assumptions underlying the development of CAPM are violated. However, rather than nit-pick it is more sensible to ask dose the theory work? Ie. Dose it explain the returns on securities in the real world?
Fortunately, the answer is yes. Practical empirical tests, whilst showing that betas are not perfect predictors of rates of returns on investments, do show a strong correspondence between systematic risk and rate of return. Certainly CAPM outperforms other models in this area, and in particular it gives a for better explanation of the rate of return on a security that is obtained by looking at its total risk.
However, you may simply be required to explain the model in outline, and discuss its advantages and limitations. For this sort of question, you do not need to get bogged down in details. A suggested brief description goes as follows.
The CAPM shows how the minimum required return on a quoted security depends on its risk. For simplicity, various assumptions are made.
a) A perfect capital market;
b) Unrestricted borrowing or lending at the risk- free rate of interest
c) Uniformity of investor expectations
d) All forecasts are made in the context of one time period only.
From this it is deduced that all investors will hold a well- diversified portfolio of shares, known as the market portfolio, which is really a ‘slice’ of the whole stock market. Although the market portfolio is not really held by investors, in practice even a limited diversification will produce a portfolio which approximates its behavior, so it is a workable assumption.
The attractiveness of any individual security is therefore judged in relation to its effect when combined with the market portfolio.
A security whose returns are highly correlated with fluctuations in the market is said to have a high level of systematic risk. It does not have much risk – reducing potential on the investor’s portfolio and therefore a high return is expected of it. On the other hand, a security which has a low correlation with the market (low systematic risk )is valuable as a risk reducer and hence its
required return will be lower. The measure of the systematic risk of a security relative to that of the market portfolio is referred to as its beta factor.
The CAPM shows the linear relationship between the risk premium of the security and the risk premium of the market portfolio.
Risk premium of share = market risk premium
The same formula can be applied to computing the minimum required return of a capital investment project carried out by a company, because the company is just a vehicle for the shareholders who will view the project as an addition to the market portfolio.
In practice many of the assumptions underlying the development of CAPM are violated. However, rather than nit-pick it is more sensible to ask dose the theory work? Ie. Dose it explain the returns on securities in the real world?
Fortunately, the answer is yes. Practical empirical tests, whilst showing that betas are not perfect predictors of rates of returns on investments, do show a strong correspondence between systematic risk and rate of return. Certainly CAPM outperforms other models in this area, and in particular it gives a for better explanation of the rate of return on a security that is obtained by looking at its total risk.
advantages of the CAPM
a) risk and rates of return a) it provisos a market based relationship between risk and return, and assessment of security given that risk.
b) It shows why only systematic risk is important in this relationship
c) It is one of the best methods of estimating a quoted company’s cost of equity capital.
d) It provides a basis for establishing risk – adjusted discount rates for capital investment projects.
a) risk and rates of return a) it provisos a market based relationship between risk and return, and assessment of security given that risk.
b) It shows why only systematic risk is important in this relationship
c) It is one of the best methods of estimating a quoted company’s cost of equity capital.
d) It provides a basis for establishing risk – adjusted discount rates for capital investment projects.
limitations of the CAPM.
a) By concentrating only on systematic risk, other aspects of risk are excluded; these unsystematic elements of risk will be of major importance to those shareholders who do not hold well- diversified portfolios , as well as being of importance to managers and employees. Hence it takes an investor – orientated view of risk.
b) The model considers only the level of return as being important to investors and not the way in which that return is received. Hence, dividends and capital gains are deemed equally desirable. With differential tax rates the ‘packaging ‘ of return between dividends and capital gain may be important.
c) It is strictly a one – period model and should be used with caution, if at all, in the appraisal of multi-period projects.
d) Some of the required data inputs are extremely difficult to obtain or estimate
a) By concentrating only on systematic risk, other aspects of risk are excluded; these unsystematic elements of risk will be of major importance to those shareholders who do not hold well- diversified portfolios , as well as being of importance to managers and employees. Hence it takes an investor – orientated view of risk.
b) The model considers only the level of return as being important to investors and not the way in which that return is received. Hence, dividends and capital gains are deemed equally desirable. With differential tax rates the ‘packaging ‘ of return between dividends and capital gain may be important.
c) It is strictly a one – period model and should be used with caution, if at all, in the appraisal of multi-period projects.
d) Some of the required data inputs are extremely difficult to obtain or estimate
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