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The Merits of the Capital Asset Pricing Model

These are the real properties that cannot easily be converted into cash and generally kept for long properties. For example real estate, equipments etc (Investorwords)

What is Capital Assets Pricing?

In today’s world it is seen that there are certain assets which give higher return than others. Hence assets pricing explains the reasons of assets which pay higher average return than others. In order to examine the fact, we consider most important aspect of trade-off that’s risk and return. Generally every investor expects and asks for bonus return for an asset including more risk. To examine the risk-return relationship lets take an example of US stocks between 1926 and 1999.during this period small US stocks yielded average return of almost 19% while large stock yielded 13% and US Treasury bills only about 4% if we see at the risk of assets as measured by standard deviation of almost the small stocks had the deviation about 40% while large stocks 20% and US treasury bills had 3% only.

Capital Asset Pricing Model (CAPM):-

CAPM which refers to Capital assets pricing model is based on the comparison of risk and rate of return with overall stock market. The basic thing which we have to keep in mind while using CAPM is that most of investors desire to avoid risk and those investors who take risks, expect to be extra bonus. It also considered that investors are "price takers" who are unable to influence the price of assets or markets. Another thing which is most important is that CAPM considers that investor is not limited in his borrowing or lending in the the risk free rate of interest.

(Banz R)

According to CAPM theory, It states that the only way through which an investor can earn more, on average, by investing in one stock rather than another is which one stock is riskier.

The capital asset pricing model (CAPM) is widely used in calculating the investment risk and what return on investment investor should expect. In order to calculate the expected return on the on the whole stock market, let's have a look over the CAPM formula.

E (Ri) = Rf + B { E(Rm) – Rf}

E (Ri) = Rate of Return,

Rf = the Risk Free Rate)

B = Beta

E (Rm) = the return which is expected on the on the whole stock market. (To be guessed what rate of return we think the overall stock market will produce.)

Beta –Capital Assets Pricing Model states that beta is the only relevant measure of a stock's risk. It is a measurement for a stock's relative volatility or in simple words we can say that it indicates the price of a particular stock jumps up and down compared with stock market as a whole jumps up and down. Let’s assume that a share price moves exactly in line with the market, and then naturally the stock's beta would be 1. A stock with a beta of 1.5 means stock would raise by 15%.

Hence we can say that Beta is the generally risk in investing in a large financial market, like the Mumbai Stock Exchange. To understand the real practical concept of this lets assume an example consider the risk free rate is 4%, and the stock market is giving a rate of return of 10.5% overall in coming year. We find that X Company has a beta of value 1.2.

What should be the rate of return that we get from this company to be rewarded for the risk taking?

Now we have to keep in mind that investing in X Company whose beta is 1.2 is definitely more risky than investing in the stock market whose beta is 1.0 that is overall stock market. So we want to get more than 10.5% rate of return. Now on putting the values in CAPM equation to calculate rate of return for an investor in company X.

Ks = Krf + B (Km - Krf)

Ks = 4% + 1.2 (10.5% - 4%)

Ks = 4% + 1.2 (6.5%)

Ks = 4% + 7.8%

Ks = 11.8%

So, if we invest in X Company, we should get at least 11.8% return from our investment. If we think that X Company will not give such a return to us, then we should look for other option that’s get the stock of other company to invest.

Birth of CAPM - Capital Asset Pricing Model

Harry Markowitz Jack Treynor, John Lintner, Jan Mossin and William Sharpe all contributed together to the theory of CAPM. William Sharpe, Harry Markowitz and Merton Miller were jointly awarded with Nobel Prize in Economics in the year if 1990.

Merits and demerits of CAPM-

CAPM calculates the rate of return over risk. It has the following merits and demerits.

Merits of CAPM

(i) Investors choose their investment portfolios on the basis of expected return and variance of return over single period;

(ii) Investors have the same estimates of mean, variance and covariance of all assets;

(iii) The capitals markets have no transaction costs;

(iv) All assets are perfectly divisible;

(v) No restriction on short sales;

(vi) Investors can borrow and lend unlimited amount at a risk free rate

Demerits of CAPM-

One of the demerits of this model is that there are many other models are also available for calculations.

Due to single time period it does not fulfil the intention of investors who wants to secure his life time consumption by the way of investing.

Some times it becomes very hard to know the status of rate of return of stocks from the value of beta as if it is higher than stocks can move either of direction that’s it may be go higher than market or lower than market while if the value of beta is low than stock will go lower than market.

A very serious problem with this model is that, in reality, it is not possible for investors to borrow stocks at the risk-free. This is so because the risk associated with individual investors is much greater than that associated with the Government.

Famous Fama and French researches rejected any type of relationship between average stock return and beta.(scribd.com)

The Fama-French three-factor model:-

Fama and French is extension model of capital assets pricing model. In this model there are two main factors as previously in CAPM there was only one factor beta which is compared with overall market. These two main added factors of fama and French model are as follows-

1-value stocks

2-small caps

Fama and French Model was a response to the CAPM in which according to fama and French there were flaws or deficiencies which were therefore overcome by their model. Fama and French (1992) argue that size and the book-to-market equity ratio capture the cross-sectional variation in average stock returns associated with size, the earning-price ratio, the book-to-market equity ratio and leverage. The book-to-market equity ratio has stronger explanatory power than size but the book-to-market equity ratio cannot replace size in explaining average returns. They propose a three-factor model for expected returns in which the variables including the return on a stock index, excess returns on a portfolio of small stocks over a portfolio of large stocks, and excess return on a portfolio of high book-to-market stocks over a portfolio of low book-to- market stocks.

(Rit – Rft) = αi + β1i (Rmt – Rft) + β2i SMBt + β3i HMLt + εit

In above written equation, SMB (small minus big) is the difference of the returns on small and big stocks, HML(high minus low) is the difference of the returns on high and low book-to-market equity ratio (B/M) stocks, and the betas are the factor sensitivities of the state variables.

Fama and French argue if

Asset pricing is rational, size and BE/ME must proxy for risk. SMB captures the

Risk factor in returns related to size, HML

Captures the risk factor in returns

Related to the book-to-market equity and the excess market return,

Rm - R captures the market factor in stock returns.

However, Fama and French (1992) show that it is unlikely as they find

Market betas alone have no power to explain average returns. They also find the

Averages of the monthly cross-sectional correlations between market betas and

The values of these two state variables for individual stocks are all within

0.15. (Griffin J and Lemmon M)

They proposed HML captures the variation of the risk factor which is related to relative earning performance. Stocks with low long-term returns which can be called as losers tend to have positive SMB and HML slopes (they are smaller and relatively financially deplorable) and higher future average returns. Similarly, stocks with high long term returns which can be called as winners tend to have negative slopes on HML and low future returns. Fama and French also show the existence of co variation in the returns on small stocks which is not captured by the market betas and is compensated in average returns. Fama and French (1993, 1996) tried to interpreted their three- factor model as evidence for a "distress premium". Small stocks with high book- to-market ratios are firms which have performed weakly and are at risk to financial distress, and hence investors have to command a risk premium.

Along with this, the model is not able to explain the momentum effect. Fama and

French report stocks that having low short short-term past returns tend to load positively on HML and high short short-term past returns load negatively on HML

The conditions are just like long-term losers and long-term winners as mentioned above. The Fama-French three-factor model predicts the reversal of future returns for Short-term winners and losers. so, the continuation of short-term returns could not be explained by the model.

Conclusion from Fama and French model

The main conclusion drawn from this model can be summarized as follows:

According to Fama and French three factor model it holds both a book-to-market equity size effect and is available on the SEM.

The Fama and French model contradict with CAPM and argued that the variation of time in betas is priced, but the statistical significance of size and book-to-market equity effects cannot be ignored. Hence, this is a strong model after taking into account the time-variation in beta

CONCLUSION

The CAPM and Fama French Model have already been discussed in this assignment. To make some conclusion we can say that CAPM and Fama French models to help investors understand the risk/reward trade-off that they face when making investments. We first introduced the CAPM, with its inherent simplicity, linking market covariance risk to expected returns. Its simplicity helps to build intuition around the concept of modelling return as a function of risk. The CAPM simplicity is also its greatest shortcoming, as the underlying assumptions limit its ability to explain and predict actual returns.

The Fama-French Three-Factor Model expands the capabilities of the model by adding two company specific risk factors - SMB and HML. The three factors in concert explain most of the returns due to risk exposure.

Various Researches have proved the CAPM to stand up well even after criticism, although it has been criticised a lot in recent years. Until there present something better itself, the CAPM will remain a very useful item in the financial management. In my view, I think, these Models help investors to make an easy decision with more informed investment with respect to personal preference regarding the risk/return trade-off.


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