The Capital Asset Pricing Model Of Theory And Empiricism

Benefits of Diversification in Investing

Describe about The Capital Asset Pricing Model of Theory and Empiricism?

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There is a saying “Don’t put all your eggs together”. Its suggests to spread the portfolio and diversify it accordingly, i.e., diversify our stocks. In world of finance, diversification implies  reducing the non-systematic risk by diversifying the investment into different securities. So to protect investor’s portfolio from a market downturn, he should diversify his portfolio. The more there is a low correlation between the returns in the assets, the more the diversification benefits will be realized. It offers investors the following benefits:

isk reduction: A stock has two types of risks, systematic and unsystematic risks. By investing in a single stock, the investor bears both the risk. But by creating a diversified portfolio comprising of different types of financial assets will reduce the overall risks. It may not eliminate risks but it helps in reducing the risk to acceptable level. In a portfolio that is diversified the risk that is unsystematic is eliminated and there is a scope is fully eliminated.

Capital preservation: It helps investor to protect their capital by allocating money to different investments. There are some investors who use capital preservation as their investment strategies.

Hedging the portfolio: It helps in enable to portfolio to give better return even when the market crumbles. By investing in both equity and bond market an investor can earn positive return from one market even when the other market gives negative return. Thus it hedges the overall portfolio against downside risk. (Burton, 1998)

The investment should be diversified among the different class of assets such as there are bonds and shares and other items as well so that maximum diversification benefit could be reaped out.. There is a chance that your portfolio’s sensitivity to market swings would be moreover dependent on the correlation between stocks of the portfolio . It is mostly observed that the bonds and the markets of shares moves opposite so it would be the perfect competition if both move opposite there would be great chance to reduce the risks involved. (Blackwell, 1983)

The following investors would not like to diversify their portfolio:

A non- risk averse investor would not like to diversify their portfolio because they are the investors who want an absolute return without having regard for risk. So they want a higher return for taking higher risk by investing in non-diversified portfolio.

A speculator would not like to diversify their portfolio because they invest in stocks by predicting future price movement in order to earn huge profits. The speculators are engaged in the practice of entering into various financial transactions to   be protected from fluctuations in the market value of a financial instrument. Speculators keep a track of the price movements and keep a proper measure of the basic value of the security. So speculators would not like to diversify their portfolio. (Fama, 2004)

So lastly though the return on a portfolio that si diversified can never exceed the return of the top-performing investment but it would be greater than the worst performing investment. Thus it narrows the range of possible outcomes.

Assumptions of CAPM Model

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CAPM is a financial model which represents the direct relationship between required return on investment held and the systematic risk. CAPM is an important area of to manage finance and is often compared to the scientific discipline as per William Sharpe who wrote in his famous publication of Derivation and the use of finance in value management. (David W. Mullins, 1982)

CAPM model has following assumptions:

All the investors in the market are rational and they are price takers only.

The investors are planning for the same time horizon

The investors have equal access to the shares and securities in the market.

Taxes are nil

The commission are not there

The investor cares about the return he expects and risk of the portfolio.

Investors are homogenising in all forms.

Borrowing and lending can be done at the same rate

Short Selling of shares in fraction are also allowed(ACCA, 2014)

The derived formula of CAPM model is as follow:

E(Ri)= Rf+ βi{E(Rm)-Rf}

Where,

E(Ri)= expected return on the asset

Rf=risk free rate of return

βi= beta value for financial asset

E(Rm)= average return on capital market

The CAPM describes that in the case of equilibrium, only beta has a price but there is price for total risk. This risk requires to be compensated for firm specific risk. In a CAPM world, every investor holds portfolios that lie on the Capital Market Line. Since CML is applicable to an investors’ combined portfolio, it is diversified portfolio with minimum firm specific risks. Thus CAPM uses the diversification concept. (Brocado, 2015)

Uses of CAPM in Finance:

It helps them to calculate the hurdle rate for taking decision on the projects in question and accordingly calculating NPV of a project as shown below:

Calculation of expected rate of return known as  (the “hurdle rate”):

Say Rf = 5%, E(Rm)=13%, beta from equivalent stand-alone traded firms: e.g., β =1.4

So: E(Rproject) = 0.05 + 1.4 (0.13-0.05) = 16.2%

Project Specification:

Initial Investment=$5,000; Cash inflows expected= $5,000 in year 3, $5,000 in year 7

Net Present Value Calculation (NPV): Adjusting the time value of money analysis for the risk of the cash flows:

Therefore NPV = -5,000 + 5,000/1.1623 + 5000/1.1627 = -$65.28.

Thus the project is not viable. (Wohlner, 2013)

Establishing fair compensation for a monopoly

Say Rf =5%, E(Rm) =13%, β= 0.7,

So, E(Rproject) = 0.05 + 0.7 (0.13-0.05) = 10.6%

Regulated Project Specification: Initial Investment= $200 million.

Therefore, required annual profit: 200 x 0.106 = $21.2 million.

Here 10.6% is the cost of equity capital and it affects the prices the monopoly will charge.

(John Dowdee, 2015)

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Application of CAPM model

As per CAPM model, E(Ri)= Rf+βi{E(Rm)-Rf}

Assumptions:

Rf=4%, βi= 1.25, E(Rm)= 10%

E(Ri)= 4% + (1.25(10%-4%))

=4% +7.5%

=11.5%

(CARRICK, 2014)

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Calculation of required return from financial asset
Rf	βi	E(Rm)	E(Ri)= Rf+βi{E(Rm)-Rf}
3%	1.15	10%	8.05%
3%	1.25	10%	8.75%
3%	1.35	10%	9.45%
4%	1.15	10%	6.90%
4%	1.25	10%	7.50%
4%	1.35	10%	8.10%
5%	1.15	10%	5.75%
5%	1.25	10%	6.25%
5%	1.35	10%	6.75%

 

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As per the Gordon Growth Model, the value of the stock is worth present value of the inflows and discount is as per the Gordon model.  The model is given by the following formula:

P= D1/(r-g) and D1= D0 x g, where,

P= current price of the stock

D1= expected dividend of next year

r= constant cost of equity capital derived from CAPM model

g growth rate in perpetuity expected for dividends and

D0= Current year dividend amount.

Given, D0= $2, g=5%, Rf= 6%, E(Rm)= 12%, βi=1.5

Calculation of E(Ri) from CAPM model:

E(Ri)= Rf+ βi{E(Rm)-Rf}

=6%+ 1.5(12%-6%)

=15%

Since in CAPM model E(Ri)= r, so r=15%

Calculation of D1= D0x g

  = 2×1.05

  =$2.1

Calculation of P

P= D1/(r-g)

=2.1/(1.15-1.05)

=$21.0

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Calculation of r given Rf= 6% and E(Rm)= 12% with following βi
βi	r= E(Ri)= Rf+βi(E(Rm)-Rf)
0.5	9%
1.5	15%
2.5	21%

Calculation of D1 given D0= $2.0 with following ‘g’
g	D1= D0xg
3%	$2.06
5%	$2.10
7%	$2.14

Calculation of P given
Sl.No.	βi	g	D1	r	P=D1/(r-g)
1	0.5	3%	$2.06	9%	$34.33
2	0.5	5%	$2.10	9%	$52.50
3	0.5	7%	$2.14	9%	$107.00
4	1.5	3%	$2.06	15%	$17.17
5	1.5	5%	$2.10	15%	$21.00
6	1.5	7%	$2.14	15%	$26.75
7	2.5	3%	$2.06	21%	$11.44
8	2.5	5%	$2.10	21%	$13.13
9	2.5	7%	$2.14	21%	$15.29

The prices of the stock that are obtained above are sensible to the following:

The beta (β) of the stock- Beta (β) is a measure of volatility and the responsiveness of a particular stock with respect to the market as a whole. The beta (β) of an investment is a measure of the risk from exposure to changes in the market. Beta is important because it measures the risk of an investment that cannot be removed by using diversification also known as systematic risk. It talks about the entire portfolio of stocks and not only on security basis, also the risks added to the diversified portfolio. As the beta of the stock rises the required return from the stock rises (derived from the CAPM model) which create a downward pressure on the stock price. Thus the beta of the stock is inversely proportional to the stock price. (For example: Compare Sl. No. 1, 4 and 7).(DeLegge, 2014)

The growth rate of expected future dividend payments- Growth means the compounded value of the shares at dividend discounting price . As the growth rate of expected future dividend payments increases, the price of the stock rises since the future dividend cash flow increases. Thus the growth rate of expected future dividend payments is directly proportional to the stock price. (For example: Compare Sl. No. 1, 2 and 3).(Stutzer, 2010)

ACCA. (2014). CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES. ACCA , 1-1.

Blackwell, W. (1983). The Capital Asset Pricing Model: Theory and Empiricism. Royal Economic Society , 145-165.

Brocado, C. (2015). Add Emerging Market Equities To Your Portfolio Now To Boost Its Diversification. Seeking Alpha , 1-1.

Burton, J. (1998). Revisiting The Capital Asset Pricing Model. Stanford Times , 20-28.

CARRICK, R. (2014). How to globally diversify your exposure to stocks. The Globe and Mail , 1-1.

David W. Mullins, J. (1982). Does the Capital Asset Pricing Model Work? Harvard Business , 1-1.

DeLegge, R. (2014). Portfolio Analysis: An Adventurous $496,000 Investment Plan. Us News , 1-1.

Fama, E. F. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives , 25-46.

John Dowdee. (2015). A Diversified, High-Income Bond Portfolio For 2015. Seeking Alpha , 1-1.

Stutzer, M. (2010). The Paradox of Diversification. The Journal Of Investing , 32-35.

Wohlner, R. (2013). Here’s Why Diversification Matters. The Smarter Investor , 1-1.