Are Capital Asset Pricing Model Useful Finance Essay

Are Capital Asset Pricing Model Useful Finance EssayThe CAPM forge has generally been attributed to William Sharpe, but John Lintner and Jan Mossin also made similar singular derivations in 1960s. As a result of the put is even known as Sharpe-Lintner-Mossin (SLM) metropolis asset set puzzle. The CAPM explains the proportionship that should out rifle between the securities expected eliminate and their risk about security tabulators. It is a direct extension of the portfolio models veritable by Markowitz and Sharpe. CAPM derives the relationship between postulate rate of returns and the systematic risk of individual securities and portfolios. The model explains how several(predicate) securities or assets in the capital mart argon priced. The CAPM provides an explicit placard of the risk premium. The CAPM can be expressed as followsThe portfolio that contains all the securities in the parsimony is called the trade 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 graphical record gives a bed as depictedThe graphical version of CAPM is also known as surety 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 implicationsRisk-return relationship for individual asset/securities.Identification of under and overvalued assets traded.Pricing of assets which suck up non yet traded in the market.Effect of leverage on cost of equity (rate of return required by equity sh argonholder)Capital budget decisions and cost of capital. (Source Capital asset pricing model Portfolio management from ICFAI result page no.91)The CAPM has a variety of applications. Capital asset pricing model utilize for decisions relating to portfolio evaluation, capital expenditure, financial backing 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, growth 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-ad buted discount rate which has been a major contribution for capital budgeting. Capital budgeting is a call in site 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 find out CAPM so as to calculate cost of capital. However the classic method for capital budgeting is to take engagement Present Value (NPV). (Source Bierman, H.J., 1993, Capital BudgetingA Survey, Financial Management 22, 24) Investors should be cautious when applying the model to re gard assets returns and to evaluate investment performance.Empirical appraisal of CAPMThe CAPM was developed on the basis of a set of unreal assumptions as the assumptions are not correct in their entirety. The CAPM must be tested a directeriorily and clear before it can be used with any real confidence. The empirical test should look for the discover results first, the positive relationship between returns and systematic risk and should appear to be linear. Second, test should attempt to tax 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 through with(p), 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 grade can be calculated for the project to be undertaken. (Jagannathan and McGrattan 1995.Limitations of CAPMCAPM 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 selective information is required. The beta factor can be found by examining the securitys 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 pee-pee a conceptual problem. CAPM is an ex-ante model that is data on expected prices are taken to tes t 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 securitys 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 invariable 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 todays life the assumption is upon as investments are subject to capital gain taxes and further adding effect 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 ascribable 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) uncertainness 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 room 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 availa ble. The estimates used in the CAPM are subject to large errors.DebateThe CAPM has been photogenic in measuring the risk and return relation since three decades. With the help of CAPM the rate of return on divergent 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 sacred scripture Financial Management by I M Pandey. But unfortunately, the empirical record is too silly to validate the way it to be used. The models problems may be due to theoretical failing or the surrealistic 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 inter preted 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 procurator 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 hang on model to validate. At the same time the researchers and practitioners have began to look for multi-beta mo dels 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 shut up 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 speculative problem is forming portfolio by sorting stocks on the basis of price proportionalitys 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 o n 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)ConclusionCAPM has been facing a lot of criticism in the young 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 2001204 Campbell et al 1997183). 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 1997147). The CAPM should be judged on the basis of insights it provides into the risk/return relationship. Without the CAPM, the cognition of the capital market and t he market conditions would have been very limited (Karnosky 199356). Every three out of iv 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(prenominal) 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. aside the model have also been used in business by analyst, researchers and firms.CAPM has been the basis for modern capital market theory since 30 years, but with t he emergence of new equity markets around the world during the last few years, accumulating research has increasingly created doubt on the models 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 extend 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.