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Capital asset pricing model has been widely acknowledged by several professionals and theorist for its acceptance and criticism since coming into use over 40 years ago (Somoye et al, 2008). The model gives one a detailed understanding of what should be noted between the risk of an asset and its expected return. However Finance professionals have diverse opinions about its
applicability which has resulted in the critical examinations of all the assumptions as postulated
with the model (Somoye et al, 2008).
A key assumption to this model is that all investors have access to the same information at no
cost even as the market is efficient (Sharpe, 1964). It provides the benchmark rate of return for
evaluating possible investments and helps one make a forecasted possibility of the future return
expected on an asset not yet traded in the market.
Furthermore, even as capital asset pricing model does not does not withstand empirical tests, it is
still widely used because of its information predictability and acceptability as a fairly good
representation of real world for important applications (Javid, 2009).
2.1 LITERATURE REVIEW
Capital asset pricing model is defined as the theory of asset pricing used to analyze the
relationship between risk and rates of return in securities (Bodie, 1970). Its birth was the work of
William Sharpe which was set out in his 1970 book "Portfolio theory and capital markets". It is a
share valuation model with respect to share investments in individual companies (Lumby
& Jones,1999, pg 260). The model explains market with the expected market price in
relation to expected undiversifiable risk. It can be seen as both a mathematical and
economic model which values stocks at the same time relating expected return to expected risk
(Grigoris et al, 2006).
Based on the model investors accept additional risk if they would be compensated with more
return. It starts with the idea that individual investment contains two types of risk
(Somoye et al, 2008); Unsystematic/ diversified risk - This is also known as specific risk. It is
micro or specific in nature to individual stocks, firm or industry and can be diversified away as
the investor increases the number of stocks in his or her portfolio. The other one is the
systematic/ Undiversified risk- This is a macro or market risks which cannot be diversified away.
This are risks companies accept while starting up a business.
(Bodie 2008, pg 280) for capital asset pricing model to work well it must be used with the
following assumptions in place. Investors should be seen to act as if the price of securities traded
has no effect on the amount of their own investment. The investors who operate in the market are
mean-variance optimizer. i.e they tend to like the highest expected return in the market which
has the lowest standard deviation. It would be assumed that investors would pay no tax on
returns. Investors would also not pay any transaction costs in respect of securities traded or
bought. Investors would borrow or lend at a risk free rate of interest. i.e. the rate for borrowing
from the market is the same as the rate of lending from the market. Investors always plan for a
single holding period even as all investment always revolve after a single period. The model
consist of a science and art (Hanif et al, 2010). A science being decision making in relation to
market portfolio construction and an art based on its realistic contribution to decision making.
Investors operate in an efficient market being that, investors analyze securities in the same way
and share the same economic view of the world. Although not all such assumptions must be in
place for the model to work, a substantial amount should be in place. "Needless to say these are
highly restrictive and undoubtedly unrealistic assumptions" (Sharpe, 1964)
2.1.1 Empirical evidence of Capital asset pricing model
The model assumptions may be positive but if it has no foretelling power then it is without value.
Many researchers, who tested the model validate how it works, used a stock market index as an
alternate market. This was done to examine the correlation between beta values and observed
returns with risk premium being the key variable in the test (Lumby & Jones, 1999 pg, 276).
Since its introduction, capital asset pricing model has, if not the most stimulating topics in
contemporary finance. Just about every financial consultant who wants to undertake an
assignment partly bases his inference with the application of capital asset pricing model. This is
because of its simplistic approach to derive investors demand and expected returns. Based on the
model, the differences in risk premium across assets is due to the riskiness of such asset which is
measured by beta. Therefore with the risk free rate in a market and the beta (depending on the
relevant asset riskiness) this would determine the expected yield of any asset.
Beta is one of the key determinants in capital asset pricing model. It is the non diversifiable risk
element while the remaining unsystematic risk element can be curbed or diversified. Beta can be
represented as (Systematic risk of a company divided by the company's total market portfolio).
The beta value of an organization's stock tells one the degree of receptivity of the expected
return on the shares relative to fluctuations in the market. Beta doesn't show the amount of
fluctuation expected in an investment return but indicate the measure to which expected returns
respond to general market fluctuations.
Fig 1: Capital market Line (Harper 2008)
Based on the above with Sharpe's assumptions in place, the expected return and standard
deviation on a portfolio of asset is represented in fig 1 with every possible combination stated on
the capital market line (blue line). This line represents the risk free rate or benchmark rate for the
market at 7% which also has a volatility of zero (Harper, 2008). It encourages lending at the risk
free rate (to the left of market portfolio) or borrowing to leverage the market portfolio (to the
right of market portfolio). The green line is the efficient frontier line which represents every
combination of assets. The point in which the efficient portfolio line touches the capital market
line (green line touches the blue line) is the highest Sharpe's ratio (Harper, 2008).
With the 7% intercept it helps prove the validity of the model since it would be the undiversified
risk that would be tested. If it's not the case then it means other factors aside the undiversified
risk are affecting the investment return.
However the inference that capital asset pricing model is undoubtedly a correct model is
debatable. Economists were of the opinion that the intercept should not be zero but a positive
number (Grigoris et al, 2006). This was to confirm they were other factors that determine the
investment return aside the undiversified risk element. This can be evidenced in the comparable
returns of larger and smaller companies, the functional dividend policy and the type of industry
in which the model can be applied.
The argument was that smaller companies with the same beta value as larger companies tend to
generate a higher return on investment than the larger companies. They also noted that
companies with higher dividend yield generated more returns than a company which had a
similar beta value but with a low dividend yield. Furthermore, the industry in which it is applied
like the oil industry in which a lot of natural occurrences dictate its return can bring about such
discrepancies. The capital asset pricing model would be a poor forecast since it has been argued
that the market portfolio is not represented in those areas.
2.1.2 Validity of the Capital Asset Pricing Model
It is said that any economic model is a linear abstract of reality (Banz, 1981). This can be
observed from the capital asset pricing model which is still been used in many developed and
developing countries despite its empirical shortcomings.
First of all the coherent breakdown of undiversified and firm specific risk is great, although
cannot be used viably to test non-financial asset component risk premium, It still stands out. Also
the efficiency of market portfolio can also be said to be valid. The capital asset pricing model
captures information easily. The model is accepted as an easy and convenient model to use for
cost of capital estimation as it captures information easily while still factoring assumptions as
required. Based on its simplistic approach, economists use it to demonstrate important ideas in
finance even when there are other models to use.
Black, Jensen and Scholes (1972) used data portfolios to test if expected returns are in line with
beta. This diversified away most of the company's specific component return by enhancing the
beta estimate and expected value generated. With this approach statistical errors that arise from
beta estimate are eliminated.
2.1.3 Challenges to the validity of the Model
Several studies have suggested that there are differences to the model theory due to the non
consideration of other significant variables that affect the expected returns.
Banz (1981) assessed capital asset pricing model to confirm if the size of a company can proffer
solutions to the differences in average returns across assets. He questioned the model on the
company size to cross sectional variation in average returns. He was of the opinion that average
returns of small company with low market value stock have a higher yield than the average
return of companies with high value stock. This he termed the size effect.
The generally reaction from Banz (1981) was that capital asset pricing model was missing some
key feature of reality. He went further to confirm the difference from capital asset pricing model
but still stated it cannot be the reason why it capital asset pricing model still be in use.
The Arbitrage pricing theory model developed by Ross (1976) is also another criticism to capital
asset pricing model. It states that the expected return on an investment is dependent on the
investment reaction to different macroeconomic determinants with independent betas and risk
premiums. Arbitrage model considers several factors unlike the capital asset pricing model
which just assesses a single factor return on the market. Although a limitation with the arbitrage
model is that identifying those macroeconomics determinants for betas and risk premium for
determining the expected value is a problem.
The paper examined if asset pricing model is any longer an issue and based on the theory and
findings it was seen that capital asset pricing model is a viable technique for efficient asset
pricing. Although there are many of its assumptions and theories which seem inappropriate or
non functional in an ideal world but many companies and research academia still use it as a
viable tool. This is because it offers powerful and intuitive pleasing predictions about how to
measure risk and the relationship between expected return and risk which is based on a single
beta value (Somoye et al, 2008).
Despite the shortcomings on the model, many companies still use the model as a toll for capital
budgeting decisions despite the existence of other models.