The Capital Asset Pricing Model came into existence in the mid 1960s. The term explains assumptions made to predict the return of an asset for its level of systematic risk. Testing market and investors change in behavioural approach thus, affecting the equilibrium condition of the assets of company. CAPM is there so that the systematic risk can be measured posing a comparison with other assets in the market scenario. This is a theoretical assessment that helps the investors to improve their portfolios and managers to find expected rate of return. Nowadays CAPM is taught to attain insights of capital market (Business week, 2005).
The CAPM helps in getting the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet the required return, at that time one shouldn't ascertain the investment. The security market line explains the results of the CAPM for all types of risks. Investors take the risk of an investment into account when deciding on the return they wish to receive for making the investment. The CAPM is a method of calculating the return required on an investment comprising of an assessment of its risk (Student Accountant, ACCA Journal 2008)
The interpersonal relationship between the required rate of interest over an investment either it is regarded as stock market securities on the other hand it can be used as in business operations. Although it is a systematic risk we can calculate with the help of the CAPM formula,
Formula:
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
Advantages of CAPM:
The CAPM has several advantages as compared to the other models for calculating required return, may be that is the reason of considering CAPM from mid 60's till date:
Investors usually have diversified portfolios to eliminate systematic risk, which could be certain but CAPM eliminating unsystematic risk as well.
The relationship between systematic risk and return has been theoretically examined further in empirical study.
CAPM model is the best approach to calculate the cost of equity as compare to other model like dividend growth model (DGM), which considers systematic risk in context of stock market.
It is superior to the WACC (weighted average cost of capital) which shows only discount rates for use in investment appraisal.
Disadvantages of the CAPM
Inspite of best results CAPM do suffers from a number of disadvantages and limitations that should be in a balanced discussion of this important theoretical model.
Assigning values to CAPM variables
The CAPM technique came into action therefore values need to be assign to the risk-free return rate, on the other hand the return on the market, equity risk premium (ERP), and last comes the equity beta. The short-term Government debt used to be a substitute for the less effective rate of return, which become flexible and lies on fact of daily basis according to economic circumstances. For a smooth volatility short term average value is ascertained. Obtaining a true value of ERP poses a challenge. The return on a stock market is the sum of the Average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP shows unstable picture over time. If we take into consideration for UK, an ERP value of between 2% and 5% is currently seen as reasonable. On the other hand approximations made regarding the uncertainty about the exact ERP value introduce uncertainty into the calculated value for the required return (Business week, 2005). The Beta values are calculated and published regularly for all stock exchange-listed companies till date. The problem that emerges gave rise to the uncertainty in the value of the expected return because the value of beta is not constant, but changes over time, thus affecting the expected rate of return. Nowdays Beta's values are intended for companies so that approximations can be used, however it's important to keep a proper check over fluctuations. In order to overcome the confusion state one should keep in mind as if dealing with proposed investment value in favour of companies having multiple projects, only proxy beta is ascertained, not the company's equity beta ((Student Accountant, ACCA Journal 2008)
Empirically the CAPM based model has not performed particularly well. However there is no consensus due to inadequate proxies for unobservable variables or a failure of the model itself (e.g. Roll's critique).
Over the last thirty years most empirical studies have rejected the hypothesis of uncovered
Interest equivalence, which basically implies that the expected return to speculation in the Forward foreign exchange market accustomed over the available information ought to be zero. In fact, the alleged "carry trade", which involve borrowing of low-interest-rate currencies and investing in high-interest-rate ones, constitute a very popular currency speculation strategy urbanized by financial market practitioners to take advantage of this "inconsistency".
Fama and French Model:
A single factor i.e. beta is ascertained while using the CAPM technique, in order to compare a portfolio inside the market as an intact. But typically, we can consider factors to an empirical model to provide an improved r-squared fit. The best identified approach similar to this regard is the three factor model developed by Gene Fama and Ken French.
Fama and French have examined those two classes of stocks having a tendency to do better than the market where as the: (i) small caps and (ii) high book value stocks till the price ratio. They therefore introduce two factors to CAPM in order to reflect as a portfolio's revelation to these two classes:
Now we can have a look over some of the portfolio's return rate, Rf is regarded as risk-free return rate, on the other hand Km is marked as return of the whole stock market. Thus, the three factor beta is parallel to the classical beta but it's not equal, since now there are two supplementary factors providing sufficient help with some of the work. SMB and HML are abbreviated for (small [cap] minus big) and (high [price] minus low). Although it is only there to assess the historic surplus over returns of small caps and thus creating a valuable stocks over the market as a whole. On the contrary terms SMB and HML are defined as, the subsequent coefficients bs and bv take values on a scale generally up to 0 to 1 then bs is equal to one that is regarded as a small cap portfolio, on the other hand when bs is equal to zero it is regarded as a large cap, lastly if the bv comes equivalent to one then it would be a portfolio having high book/price ratio. (Fama and French, 1992).
Fama and French (1992) developed the pricing model that was combined these factors (equation: b); market (following CAPM Model), size and Book to Market Ratio: BE/ME Ratio to use in forecast and explain the average return of stock. Then, Fama and French studied for correct and efficiency of model at times. Thus all the findings of the research study can confirm the model of Fama and French to be able to explain the average return of stock in stock exchange which is far better than that of a CAPM model. According to Fama and French, 2006, Capital Asset Pricing Model (CAPM) is powerful and intuitively pleasing predictions about risk measurement and the relation between expected return and risk. Unfortunately, it was found that the empirical result of the model is so poor. Thus, the business mainly relies on the empirical study. If the main aspect is not overcome what is the need of formulating long variations.
In addition, as the main factors besides the CAPM beta truly explains the cross-section of returns, thus helping the portfolios of the business. The Fama-French (F-F) factors SMB and HML mutually provide statistically considerable explanation regarding the power diagonally on all the sample return horizons. We argue that SMB and HML proxy for measures of market risk not captured by the CAPM.
Empirical Approaches to Asset Pricing
Pricing Model is very popular and apply broadcast in the present. Help in improving industries constantly. Getting started with the Sharpe (1964), Lintner (1965) and Mossin (1966) presenting Capital Asset Pricing Model: CAPM shows the relationship between the average return of stock and market risk factors. The other researchers oppose the above statement and they did not agree to the facts of CAPM theory because they think there are various other factors available above one factor. Thereafter, Ross (1976) introduces a model that peruses many factors for assessing the return of stock. The model is called Arbitrage Pricing Theory: APT. Although APT Model is far more efficient than that CAPM, APT Model only lack of few general variable. The main elements of model poses different style depending upon economic conditions of the business and try to scale or draft business in each country, therefore APT Model is not that much famous as expected. ATP model can add many factors to model however it is based on complex statistical especially multicolinearlity. Although in practical life we don't find use of APT as it is more confined to discuss in academic, we can rarely find it in practical equations (Fama, E. F., and K. R. French, 2004)
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There are many other examples of empirical studies with respect to the CAPM are Connor and Sehgal (2001) empirically examined the Fama-French three factor model of stock returns for India. It was found that a cross-sectional mean return that is self explained by market, size and book-to-market factors, not only by the market factor but also through the business point of view. There after some of the results shows lack of proper or expected link between common risks factors in earnings average in stock returns. Chawarit (1996) studied about comparing CAPM and APT model for elucidation of predictions for the return of stock in the Stock Exchange of Thailand among the early 1990-2000. At hand there was divided into two parts of times to figure out the economical crisis on or before just after carrying out the research. As a result of it they came to point where APT model is better than CAPM model to explain the return of stock in the Stock Exchange of Thailand for both times.
Conclusion
However the studies found that Fama and French Model appropriate to describe in asset pricing better than CAPM but Fama and French Three Factors Model fails to show any financial theory support among the new variable thus, effecting the desired rate of return and risk of both variable used in CAPM formulation. At last they found appropriate relationship between both the variable and required rate of return. Moreover, the risks in asset pricing have other variable that fits in or involve more than size effect and value effect. In addition, CAPM also has great advantage over true aspect of general and plain method on the other hand Fama and French Model are limited to general specification and find it difficult procedure as whole result in unpopularity of Fama and French Model whenever compared with CAPM Model.
