The Capital Asset pricing model is very important tool that enables the investors or financial analysts to evaluate the risk involved in doing investments. In reality, the investors are always concerned about the risk involved in the investment portfolio, some investors are more risk averse or some are less but everyone is concerned about the rate of risk associated with expected return. On the basis of this analogy, Jack Treynor (1961, 1962) and William Sharpe (1964) came with the model called CAPM (Capital Asset Pricing Model). Their main aim was to know the risk associated with the investment. In this regard, the writer of this essay is going to evaluate the relative merits of the capital asset pricing model with the other pricing models such as APT, Fama and French Models.
CAPM (Capital Asset pricing Model)
The Capital Asset Pricing Model was developed in the mid 1960's by William Sharp. This model is based on various assumptions about the markets and investors behaviors. It gives investors certain condition of Equilibrium that allows them to predict the expected return of the investment for its level of systematic risk. The general Formula of CAPM is given below.
Merits of CAPM from the evidence of Empirical approach
The beauty of CAPM lies in pricing an individual security or a portfolio. The CAPM is simple a model it uses SML (Security market line) for pricing individual securities in relation with the associated risk class. The SML makes the Investors know about the portfolio of investments by virtue of which it enables investor to calculate and identify which share is best to buy and has more return less risk. This is explained graphically below
In Graphically intercept on Y-axis determines the risk free rate beta= 0, and when beta =1, determines the expected return on market. So, now from the graph it's evident that it's possible to obtain any combination of risk and expected return along the slope of graph. The SML is important feature of SML as it determines whether an investment offer good return. This is one of the important features of CAPM but this is at the same time based on certain assumption which is very hard to full. Some of the Assumptions of CAPM are given below as:
Diversified portfolio hold by investors
According to this assumption investors will only include systematic risk of their portfolio and since investors ignore the unsystematic risk
Single-period transaction horizon
CAPM assumes holding period in a standardised manner, in order to do cross country comparable of returns. And also return over six months can only be compared with the returns of six months in another country, not with return over 12 months, however, holding period of one year is usually used.
Investors can borrow and lend at the risk-free rate of return
CAPM was developed by portfolio theory, as this theory suggest that CAPM will provide minimum level of return to investors at a risk free rate. This risk free rate of CAPM is graphically represented. It is the point on y-axis of fig 1 which is cut by the line called SML, this point is assumed as beta zero which signifies risk free rate.
Perfect capital market
As per this assumption, all the securities are first valued correctly according to portfolio theory and then after their returns are plotted on to the SML. In order to draw this SML perfectly, then it has to follow some pre-requisites. Like, it has assumed that there is no processing fee and the information is correct and easily available. In the view of making every investors know of the risk in the system and at the end no investor could blame that he has lack of information. In that context, Investors are risk averse, rational and desire to maximise their own utility. There are also some more assumption which are as under:
Now according to CAPM, investors will first choose the market portfolio M, as the optimal portfolio. In this case M is the best portfolio as per CAPM and has more chance of expected return as it lies on the SML. Secondly, Since the M lies on the efficient frontier. So as per the said assumption of CAPM, all the investors have same information and will buy shares which lie on the SML line and M is the extreme position of expected return. However in this case, investors will do investments on the asset portfolios which lie on SML and depending on the risk taking ability of investor, it will ranges it investment from the zero value of beta till 1 value of beta. This will indicate the tendency of paying the risk premium on the market portfolio and would be proportional degree of risk aversion and its own risk. The risk premium (beta) will be equal to expected return of market minus rate of risk free rate.
APT (Arbitrage Pricing Model)
Arbitrage pricing theory model is one of the important pricing model used in investing portfolio. This model receives lot of attention in the financial literature as it is devoid of CAPM assumptions. This model was developed by Ross in 1970. APT equilibrates across market securities through arbitrage driving out mispricing. In other words it helps the investor to identify the two securities in such situations when an investor sell expensive one and buys cheap one and thus generates profit on the spot without any risk. The general formula for APT is given as:
The Fama and French model is a three factor model and is much more advanced than CAPM and was developed by modifying other investing model like CAPM or APT (Asset Pricing Model). This model is largely used in portfolio management. This model came into existence in 1993 by Eugene Fama and Kenneth French. This model is now broadly used by most of fund managers and investors in order to analyze the risk and return associated with market.
The aim of development of Fama and French three factor model was to over the poor performance of CAPM which was realized due to the empirical evidence of its results. As the CAPM was single dimensional model and was considering only market risk into account and was ignoring other factor that might influence the expected return of assets. Fama and French model is most evaluated model than any other investing model. As it includes three factors for calculating the risk associated with expected return in addition to CAPM which was considering only market risk (beta) and the other two factor that it considers are most important factors, size or market capitalization and value or book/ market ratio of an instrument. The general formula for three factor model of Fama and French model is given as:
Critics of Models
CAPM is a single factor model, which means that security expected return depends on the single factor beta, but in reality there are various other factors by which expected return is influenced.
The assumptions made by the CAPM, these assumptions are focused on the relationship between return and systematic risk. However, these assumptions are unrealistic and are very less likely resemblance with the real world. While in the real world investment decision are taken by companies or individual and in the real world, the CAPM is always being criticized because it works on the hypothetical assumption on which its based.
Three factor Fama and French model is widely accepted but has some limitations because according to Fama and French model, investor can yield high profit by investing in small caps but investing only in small caps can lead to certain problems especially in high volatility period. In this case investors need to diversify their portfolio and be aware of these risks as well.
Conclusion
At the end of this study, this is quite evident that CAPM has many limitations but still then it's preferred by some investors to evaluate the cost of equity because CAPM is considered only systematic risk reflecting reality to some extent and ignores the unsystematic risk. However, CAPM is based on the portfolio theory and follows many assumptions for processing which are unrealistic and are very difficult to full fill them. CAPM also assumes that the rate of lend should be equal to borrowing which violates the basic objective of financial institutions, because financial institution run on the difference in the lending and borrowing rates. More three factors Fama and French model is widely used and accepted by investors and Fund managers. In Fama and French model, investors can use add on to this model, in order to enhance their rewards? Now from the Academic point of view, CAPM is considered back bone of financial analyst, In order to understand any financial instrument fully, one has to first understand the CAPM because all the financial tools are based on CAPM or we can say that Every model in the financial analysis are the extension of CAPM.
