Advantages Of Capital Asset Pricing Model

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

This essay will highlight the use of Capital asset pricing model ( CAPM ) to be considered as a pricing theory model for assets . CAPM model helps investors to analyse the risk and what expectation to keep from an investment (Banz , 1981) . There are two types of risk

This model is an expansion of the CAPM and it includes two additional variables, taking into account size and book to market factors, as explanatory variables expressed within the model as SMB and HML. The Capital Asset Pricing Model (CAPM) and Fama & French’s three factors model are both models account for the expected returns for stock albeit using different variables to distinguish and add reliability to the predictions of these estimated returns. However, the CAPM uses only one factor to determine the riskiness of the marketplace, Beta, whereas Fama & French expands on this model, incorporate another two factors to establish the risk, Small minus Big (SMB) and High Minus Low (HML), which take into account the relationships between market and share size. Hence, in Fama & French’s findings, stocks with higher beta did not always perform better. The Three Factor Model is indeed preferred at predicting the returns of stocks, in correlation with each models risk factor.

To reduce a firm’s specific risk or residual risk a portfolio should have negative covariance or rather it should have no variance at all, for large portfolios however calculating variance requires greater and sophisticated computing power. As such, Index models greatly decrease the computations needed to calculate the optimum portfolio. The use of such Index models also eliminates illogical or rather absurd results. The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such models used to calculate the optimum portfolio.

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

The CAPM model can be used to analyze the performance of a portfolio of investments. The model should be calculated by comparing the return of assets (Ri) minus the return of risk-free cash (Rf) of the fund against those numbers of a known index with historical data (Rm). With least-squares regression, a straight line has to be drawn through the points to finish the model. Alpha represents the point where the graph starts and beta the slope of the regression line. Alpha is the number that represents the fact of how well the fund did against the CAPM model. A positive alpha means the fund did better than CAPM predicted and negative the opposite. R² represents the ‘fit’ of the

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

According to early academic researches, CAPM seems to have some problems when examining assumptions and empirical testing. Researchers attempt to develop a new model by improving the weak points and make it more realistic which enable investors understand more about financial market situation. Bodie et al. (2014) state that multifactor model could provide better explanation of security returns. Merton (1973) develop ‘Intertemporal model’ to imply that by using beta as a risk measure alone might not yields efficient results in the real world. Therefore, he suggests that other factors could be involved in the calculation. It is clear that he suggests investors to consider not only market risk but also extra market source of risk. Moreover, he mentions that CAPM has a limitations on the economic way of thinking because there are two important factors which are income and many consumption of goods are not be considered. These two factors are changing over time and relative to price.

In this trend, there are several models to support this view of these investors, including the Modern Portfolio Theory (MPT), Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) (Fama and French, 2004; Perold, 2004). They have been the main instruments that the rational expectation based theories have been deploying. However, this traditional paradigm has been analyzed by a number of researches that the information should not be considered to have a very important role in affecting investors (Miles and McCue, 1984), Titman and Warga (1986), Lusht (1988) and Liu and Mei (1992).

CAPM model builds on the model by Markowitz(1959).Markowitz assumes investors to be rational and risk averse. The model is one period model in which investor chooses portfolio at time t-1 in anticipation of stochastic return in period t. He uses mean variance criterion that states that investor will either choose highest expected return portfolio for given level of variance or lowest variance for a given level of expected returns

Even though many articles are conducted to critically study the capital asset pricing model ( CAPM ), it is widely used around financial

Generally, researchers are interested in studying factors that can be applied to predict asset prices. Relied on Markowitz (1952)’s earlier work on diversification and modern portfolio model, it is known that idiosyncratic risk can be diversified away and only systematic risk matters to investors. Treynor (1961), Sharpe (1964) and Lintner (1965) independently contributed to the CAPM to explain the relationship between the systematic risk factor and securities returns. This emphasize the importance of systematic risk for investors to estimate asset price in order to earn excess return on market.

In order to prove the validity of CAPM model in Indian Stock Market Fama and MacBeth’s traditional approach was used as the model to prove the hypothesis. The analysis period is taken from year starting 1st January, 1999 to 31st December 2013, a total time period of 15 years. This period was divided into seven 9-year sub-periods with eight overlapping period. The periods are been continuously overlapped to reduce the variability of the beta co-efficient that were estimated.