This study will examine the advantages and the drawbacks of the CAPM model, the suggestion made by CAPM model related to asset return it may be feasible to derive equilibrium price. There will be review about the main areas where the CAPM may not work well. Some people still claim that CAPM is a practical item in the financial management toolkit whereas others suggest that CAPM is dead. The empirical and theoretical problem of CAPM and the main factors of why it has failed would be examined in this study. There will also be review about the consumption capital asset pricing model (CCAPM) whether it is more useful for financial industry than CAPM model.
Capital asset pricing model has significant impact on financial economics. This theory indicates risk and return for all kinds of investment. The theory indicates reasonable tools for calculating the risk and the cost of capital for the investment, the model is practical concept for company and investors determine their rate of return an asset that will be added to the investor portfolio. According to the investor portfolio, the overall risk of a single asset is experiencing two kinds of risks: diversifiable which is called as unsystematic risk and non diversifiable risk (systematic risk). Beta is utilised to measure systematic risk. Systematic risk explains the risk inherent to the whole market. Economic meltdowns, political issues, and interest rates demonstrate causes of systematic risk. The beta is an influential tool of CAPM model: individual investors may utilise a stock's beta to sort out the risk of security against its own market. The greater beta demonstrates higher risk in investment in asset with higher rate of return. Capital asset pricing model can be written as:
E(R_i) - R_f = \beta_{i}(E(R_m) - R_f)\,
E(Ri) demonstrates the expected rate of return on asset that can be obtained by adding the risk free rate of interest (Rf), and (βi) is the sensitivity of the asset returns to the market return, the covariance of an asset return is demonstrated by i, and E(Rm) explains the average return on the capital market that depends on the risk free rate of interest.
The risk cannot be eliminated by diversification. The systematic risk has an impact on wide range of securities. For instance, worldwide credit crisis has adverse influence stock markets. This risk can be demonstrated as non diversifiable. Nevertheless, market risk indicates whole market factors that can go down the value of asset. Currency, interest, equity risks are indicated in the market risk and the risks are being evaluated to estimate and determine the actual rate of return on asset.
βi explains the sensitivity of the asset returns to the market returns which is very influential factor of the market return.
The formula is estimated by dividing the covariance of the return on the capital asset(Ri) multiplied by the return of the market(Rm), variance of return market.
CAPM has several restrictions, investors who does not like taking risks, maximize their expected utility. However , in reality several investors who have portfolio of risk free and risky assets, could maximize their ability function. In other words, investors who take risks, will be able to maximize their economic utility. Moreover, homogenous assumptions related to asset returns that indicates normal distribution, that is not often accurate while the asset return may not distributed accurately. Variance could examine the measure of risk indicated whether the distribution is appropriate.However, this results in several mistakes when general distribution take places. According to the CAPM assumptions, investors are able to borrow or lend at the risk free rate. However, in practice it does not occur, investors must exposed to risk premium and inflation with the risk free rate as investors borrow or lend money.
Investors are able to obtain all the information at the same time through the CAPM. Nevertheless flow of information may be transpired. Several investors can obtain the new information earlier than others, some private information may also be out of the market. Furthermore, several information could be wrong which is related to assets. Moreover, taxes and transaction costs does not exist in CAPM model. Nevertheless, this is not often occurs. There are least transaction costs and tax must be paid by each investors for each transaction of stocks buying or selling.
The CAPM model can not examine investor's all assets. It is impossible to test CAPM emprically because it does not indicates each investors's assets. Dougle Breeden tried to deal with the issue which is related to the CAPM model. According to the Dougle Breeden, CAPM is not successful due to the time varying investment opportunities and the risk of particular assets is being estimated by static's which is not often accurate. Douglas Breeden found the consumption capital asset pricing model which is known as CCAPM. However, the model failed to provide a good remedy of the cross section of the return on assets. As a consequence, CCAPM model was not accepted. Nevertheless, the several CAPM assumptions utilised to evaluate the systematic risk of lots of portfolias and the cross section of size of returns.
There are several weakness of the capital asset pricing model. According to the Roll and Ross(1996), the beta is dead, or at least fatally ill. Beta can examine the bahaviour of security returns. By contrast, Kothari and Shanken (1995) suggests that beta is alive if yearly returns are utilised as input data. Beta is used for market returns, its calculated value is distorted if the returns are compounded by market frictions. As a result, the main problem is the effects of market frictions that decrease the speed of the arbitrage processes of the market. Beta is alive when there is no friction in the market. By contrast, if market frictions due to transaction costs, information assmmetry, the arbitrage slows and the power of beta will compound. Therefore , beta requires help from other factors to obtain explanotory power.
According to the Roll , Ross, and Fama, beta does not have capability to examine cross sectional variation in equity returns, however,variables like size and book to market value of equity indicates some capabilities. The Roll and Ross suggest that beta can not estimate risk, these two economists utilised that as a proof against availability of the capital asset pricing model.
Pettengill Sundaram and Mathur(1995) suggests that the positive correlation among beta and returns estimate by the CAPM that is determined by expected returns instead of realized returns. According to this assumption, as the surplus market return is negative in this circumctances and beta has negative correlation, with dual and realized returns, a good correlation was developed between beta and returns.
Sundaram and Mathur (1995) argues that, a positive correlation is often expected between β and expected returns. However, this correlation is conditional on the market excess returns as realized returns are used for tests. According to the Sundaram's study, systematic relation occurs between β and returns for the total sample periodand is unchanging through subperiods and through months in a year. Moreover, a positive tradeoff between β and average portfolio is noticed. As long as the concerns are about the poor relation between beta and the cross section of returns become to be unfounded, the outcomes help the continued utilise of beta as a weigh of market risk.
Fama and French argues that the influence of the B/m rate may be traced back to market frictions that slows the arbitrage process. As a result, it has adverse effect on explanatory power of beta because of observed returns being compounded by market frictions. Then, it may estimate that the powerof beta can be strenghten if beta is reinforced to include these market frictions. According to the Fama and French(1992), the broad stock market beta can not demostrate the distinction in return between portfolios with high and low book market equity rates. Fama and French developed an evidence opposed to the CAPM. The model has been providing false calculation for long time.
Issues can occur as utilising the CAPM to estimate a project specific discount rate. For instance, one challenge is obtaining suitable proxy betas, as long as proxy firms hardly conduct only one business activity. The proxy beta for investment project have to be distentangled from the firms equity β. It can be done by treating the equity β like an average of the betas of few distinct areas of proxy firm acts, influenced by the share of the proxy firm market value appear by each activity. Nevertheless, knowledge about relative shares of proxy firm market value may be challenging to gain. A same complexity is that the ungearing of proxy fimr betas utilises capital structure knowledge which might not be available. Some firms have compilicated capital structures with lots of sources of finance. The rest of the firms can have debt that is not traded. The simple expectation is that the beta of debt is zero will result in incorrect in the estimated value of the project specific discount ratio.
One drawback of utilising the CAPM in investment preassessment is that the assumption of single period horizon is probability with the multiperiod nature of investment preassessment. As CAPM variables might be predicted stable in consecutive future periods, experience includes that this is not practical in reality. (http://www.accatrainer.com/upload/1804754796)
The CAPM is utilising on the whole world in different aspects of economic goals like calculations of the coast and capital for company, expectations of the estimation of risk and the correlation between expected returns , and computing the performance manage portfolios, CAPM is one of the most common tested models. According to the emperical tests CAPM indicates adequate evidence about the issues. For instance, CAPM can not measure the cross section of the average return on assets.
According to the Jensen(1968) suggestions about the outcomes are not great for the CAPM. The main reason behind this suggestions is because after testing the cross section regression of average asset returns on calculates of asset betas. The issue intelligible error in estimation of beta as Jenson utilised to evaluate average returns.
According to the Blume(1970) and Stambaugh(1982) who utilised time series regression, obtained the evidence that the correlation between beta and average return is too flat. This is because the exceed asset return on the market return are negative corelated that indicates greater betas and positive low beta. Therefore, as long as the β is the most important variable of the CAPM model, the model can not examine the impact of asset returns. By contrast, it is not simple to claim about the availability and meagerners of CAPM by tests because there are not accessible correlation between expected return and the effiecient market portfolio.
Conclusion
There are several issues about CAPM model. For instance, the CAPM model considers past data and the beta should not be utilised completely for the future volatility of return. As a result, the expected return predicted by CAPM may not be accurate. According to the CAPM model, there is no transaction costs and tax and the assumptions of the CAPM occurs only on efficient market, investers accepted as rational individuals which is not possible in the real world.
Alternative models have not developed to demanstrate better ability to predict expected returns. Although there are lots of criticism about the availability of the CAPM formula, the model is still utilised by financial industry for estimating expected returns and investment risk. CAPM model indicates one beta that serves as the overall estimation of systematic risk and future cash flows. However,CAPM does not sufficient to calculate the expected returns and risks which means that all investors do not utilesed CAPM for decision making process.
