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Essays on capital assets pricing model
The capital asset pricing model: A critical literature review
Capital asset price-a theory of market
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Introduction Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002). From my perspective, the usefulness of CAPM is directed towards efficient investment decision making and strategic management. Moosa (2013) remarks CAPM to be a supportive model in ‘evaluating the performance of managed portfolios and for investment purposes’. Assumptions underlying Sharpe and Lintner’s CAPM: 1. ‘All investors have identical expectations about security rewards and risks 2. There are no investment constraints 3. There is a unique risk free borrowing and lending interest rate 4. All investors want to maximise mean variance utility functions 5. Investors are risk averse 6. There are perfect market conditions; no transaction costs, no taxes’ (Da, Guo and Jagannathan 2012). The following essay will expand on the usefulness and flaws of CAPM and other asset evaluation frameworks and in the end showing that despite all the evidence against CAPM it is still a useful model for determining asset investments. CAPM is a useful model According to Perold (2004), ‘CAPM can be served as a benchmark for understanding the capital market phenomena that cause asset prices and investor behavior to deviate from the prescript... ... middle of paper ... ...factor models (Bhatnagar and Ramlogan 2012). The two models APT and CAPM should not be seen as alternatives because CAPM attempts to describe the underlying relationships of the market, as opposed to APT, which provides an explanation of current market conditions (Laubscher 2002). Such testing assessments will increase the understanding of risk and return relationship and stock markets pricing instruments. Although the Fama and French three-factor model operates slightly better than CAPM, it does not indicate that CAPM is impractical to use (Hibbert and Lawrence 2010). Finally, Welch (2008) established from his research that 75% of finance academics recommend using the CAPM for commercial capital budgeting purposes, 10% commend the Fama French model and only 5% recommend an APT model. Therefore, Sharpe and Lintner’s CAPM is a beneficial framework.
Block, S. B., & Hirt, G. A. (2005). Foundations of Financial Management (11th ed). The
We cannot deny that APT is effectively applicable when explaining performance of investment portfolios, this has been researched and tested by a number of scholars. Most recently Ramadan (2012) carried out a test of validity of APT in the Jordian Stock Market, his findings were that macroeconomic variables as well as market indicators explained 84% of the variation in returns on his chosen market portfolio. Another finding was that the effect of certain variables converse when comparing industries within the market. (Ramadan,
Many investors can benefit from using newer financial instruments and critical analysis. The tenth edition of this book also provides a clear description of the academic...
(Hillier, Ross, and Westerfield, 2010)And they use CAPM to compare stocks ' expected return estimated by CAPM to buy the cheapest stock. Beta coefficient is the most difficult estimated value in CAPM and this is the most important value in CAPM which used to measure the market risk of an asset. Beta is 1 when the percent of change of share price and market price are the same. When the Beta is larger than 1. For example, beta is 2.0 means when the market price increase by 10% then the share price will increase 20% and vice versa. Therefore, investors can invest their money in those stocks with lower beta when the market price decrease and invest in stocks with beta larger than 1 when the market price increase. This model is widely used in Investment. Beta is calculated with historical data and the length of data is also very important to the variance of beta. The longer the time the more stable the variance is. However, if the term is too long, the change of business operation, market, technology, competitive force and the feature of the market will affect the value of beta. Besides, many popular index funds give investors a chance to hold diversification at low cost.
Traditionally active management has been measured by tracking error, the standard deviation of the portfolio’s returns relative to the benchmark. But this approach has built-in limitations: because tracking error is based on historical returns, it tells little about the underlying composition of the portfolio and the strategy pursued by the particular manager. Tracking error is also dependent on and sensitive to short-term...
Fama, E.F. and French, K.R. (2004). The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic Perspectives, 18, 3, 25-46. Retrieved December 2nd, 2011 from jstor.org
In addition, we examine whether the variables are significant or not and should therefore be considered or left out of investment decisions.
The supporters of the efficient market hypothesis believe that active management is a largely wasted effort and does not support the expenses incurred due to the mispricing of stocks (Barberis and Thaler, 2003).Therefore, they advocate passive investment strategy that makes no possible attempt to beat the market. A passive strategy involves minimum input and instead relies on diversification of the portfolio in order to match the performance of the market index. Passive management is usually characterized by a buy-and-hold strategy because the efficient market theory indicates that stock prices are at fair levels, given all available information and it makes no sense in frequent buying a...
The concept of 'efficient market hypothesis' was introduced by Eugene Fama in mid-1960s. According to this concept, the powerful struggle in the capital market leads to reasonable valuing of debt and equity securities. The perception is based on the replication of related evidence in market prices of the securities. If only past information is reflected in 'weak-from efficient markets; past as well as present information is reflected in 'semi-strong form efficient markets'; past, present, and future information is reflected in 'strong-form efficient markets'.
Finance is very essential sector in all kind of organization to be successful. It contains many financial theories which have been developed throw the years depends on special circumstances such as time, money, demand and supply. One of the important financial theories' is the capital asset pricing model which gives the investor individuals or companies the ability to be more realistic in their investments by taking market risk into consideration. This paper will explain what the capital asset pricing model is, then it will descript the CAPM theoretical underpinning and it will conclude with evaluating the CAPM.
Firstly, portfolio theory has become an essential strategy in the modern investment market. In general, according to Elton (2011), it is a common situation that each person may possess a portfolio which is combined with real assets such as a vehicle or a house, including financial assets such as stocks
Investment professionals emphasize the importance of including stocks in any individual long-term strategy because of their historically better performance compared with other investments and inflation. Most of the investors believe that stocks are “efficiently priced,” meaning that their prices reflect all relevant information, so that it is difficult to consistently outperform the market through active management. Therefore, a mutual fund that seeks to reflect the market rather than to beat it can be an easy and cost-effective way to gain broad equity exposure.
MPT is defined, according to investorwords.com (2005), as an overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially measured by alpha, beta, and R². MPT utilizes several basic statistical measures to develop a portfolio plan (Gitman, et al, 2005). Included are expected returns and standard deviations of returns for both securities and portfolios, and the correlation between returns (Gitman, et al, 2005). Detailing the mathematics of diversification, Markowitz proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics (riskglossary.com, 2006). This theory proposes that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio (investorwords.
In Dempsey’s (2012) 'The Capital Asset Pricing Model (CAPM): The History Of A Failed Revolutionary Idea In Finance?', it is argued that the CAPM fails as a paradigm for asset pricing. Due to the many questions and doubts that were brought about on the CAPM, Fama and French (2004) had included a few more add on to make the model of CAPM a better fit. However, this means that the model is being developed to fit the data, this causes a lot of the intuition of the model to be desired. Dempsey (2015) mentioned that the CAPM has not been quite successful in modeling the past share prices movement. Tests have been conducted to compare the model of CAPM with the history of past share price movement, and it is shown to not provide a good fit. Furthermore, empirical analysis indicated a risk-free rate that was greater than the existing one (Kürschner, 2008). In addition, there were early tests of the CAPM which indicated that greater share returns were commonly associated with higher betas. These results were taken as proof to support the model of CAPM while parts of the findings that contradicted the CAPM to be a fitting model of asset pricing did not discourage any interest for the model (Douglas 1967). To add on, the CAPM assumes that risk is estimated with the standard deviation of an asset's systematic risk, comparative to the standard deviation of the market of its own (Roll, 1977). Even though the
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.