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Essays on capital assets pricing model
The capital asset pricing model: A critical literature review
Capital asset price-a theory of market
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Introduction Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002). From my perspective, the usefulness of CAPM is directed towards efficient investment decision making and strategic management. Moosa (2013) remarks CAPM to be a supportive model in ‘evaluating the performance of managed portfolios and for investment purposes’. Assumptions underlying Sharpe and Lintner’s CAPM: 1. ‘All investors have identical expectations about security rewards and risks 2. There are no investment constraints 3. There is a unique risk free borrowing and lending interest rate 4. All investors want to maximise mean variance utility functions 5. Investors are risk averse 6. There are perfect market conditions; no transaction costs, no taxes’ (Da, Guo and Jagannathan 2012). The following essay will expand on the usefulness and flaws of CAPM and other asset evaluation frameworks and in the end showing that despite all the evidence against CAPM it is still a useful model for determining asset investments. CAPM is a useful model According to Perold (2004), ‘CAPM can be served as a benchmark for understanding the capital market phenomena that cause asset prices and investor behavior to deviate from the prescript... ... middle of paper ... ...factor models (Bhatnagar and Ramlogan 2012). The two models APT and CAPM should not be seen as alternatives because CAPM attempts to describe the underlying relationships of the market, as opposed to APT, which provides an explanation of current market conditions (Laubscher 2002). Such testing assessments will increase the understanding of risk and return relationship and stock markets pricing instruments. Although the Fama and French three-factor model operates slightly better than CAPM, it does not indicate that CAPM is impractical to use (Hibbert and Lawrence 2010). Finally, Welch (2008) established from his research that 75% of finance academics recommend using the CAPM for commercial capital budgeting purposes, 10% commend the Fama French model and only 5% recommend an APT model. Therefore, Sharpe and Lintner’s CAPM is a beneficial framework.
In the following essay I will be comparing and contrasting the effectives of capital asset pricing model (CAPM), Arbitrage Pricing Theory, and the Fama-French three factor model when estimating the cost of capital and explaining performance of investment portfolios.
Many investors can benefit from using newer financial instruments and critical analysis. The tenth edition of this book also provides a clear description of the academic...
The aim of this report is to evaluate and validate passive investment strategies and advantages of having index funds in the portfolio. The importance of passive investment strategy is initially justified with the help of theory on efficient markets. The report then provides evidence that indexing still is a vital aspect of investment strategy and is not influenced by the efficient market theory. The report also gives a brief overview on how investors utilize indexing to minimize transaction cost by replicating the market index in their portfolio. Further, the success of indexing in US, UK and bond markets is highlighted with the help of evidence from past research on passive investment strategies. The later section of the report provides brief introduction of behavioral finance and how psychological biases affect investor’s behavior and prices. It also provides its contrasting viewpoint with respect to the Efficient Market Hypothesis (EMH) and analyzes the effects of mispricing on average returns achieved by investor.
However, EMH has been the most controversial subject of research in the field of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences to explain human investors’ behaviors. 2. What is the difference between a MAIN BODY A generation ago, it was generally believed that security markets were efficient in adjusting information about individual stocks and the stock market as a whole (Malkiel, (2003)).
Fama, E.F. and French, K.R. (2004). The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic Perspectives, 18, 3, 25-46. Retrieved December 2nd, 2011 from jstor.org
Graham and Harvey surveyed the CFOs of 392 U.S. firms and found that when estimating the capital of assets,73.5% of respondents use the CAPM.( Graham, J. R., and C. R. Harvey,2001) It is a model which uses simple formula to evaluate asset pricing and investor behavior. This model is absolutely the method with most investors used, but many financial experts raise an objection to the veracity of this method in the recent years. Later in the main body of the essay will discuss these questions. In the first part of the essay will introduce the CAPM and the main factor of this method. Secondly, is the discussion of the uses and limits of the CAPM while evaluating the potential investment of a firm 's
Block, S. B., & Hirt, G. A. (2005). Foundations of Financial Management (11th ed). The
Snow Capital Management’s investment strategy is driven by a contrarian, fundamental, relative-value philosophy that manages to combine Active Share with margin of safety benefits crucial to investors. Our portfolios deliver true active management, as measured by Active Share. But we are guided by the time-tested principles of contrarian, relative-value investing: we invest only in those companies whose shares trade below their intrinsic value, providing a margin of safety. These principles guide Snow Capital Management’s fundamental research and investment decisions. For investors who are seeking true active management while maintaining a wide margin of safety, Snow Capital Management portfolios offer the best of class.
In addition, we examine whether the variables are significant or not and should therefore be considered or left out of investment decisions.
The concept of 'efficient market hypothesis' was introduced by Eugene Fama in mid-1960s. According to this concept, the powerful struggle in the capital market leads to reasonable valuing of debt and equity securities. The perception is based on the replication of related evidence in market prices of the securities. If only past information is reflected in 'weak-from efficient markets; past as well as present information is reflected in 'semi-strong form efficient markets'; past, present, and future information is reflected in 'strong-form efficient markets'.
Investment professionals emphasize the importance of including stocks in any individual long-term strategy because of their historically better performance compared with other investments and inflation. Most of the investors believe that stocks are “efficiently priced,” meaning that their prices reflect all relevant information, so that it is difficult to consistently outperform the market through active management. Therefore, a mutual fund that seeks to reflect the market rather than to beat it can be an easy and cost-effective way to gain broad equity exposure.
Finance is very essential sector in all kind of organization to be successful. It contains many financial theories which have been developed throw the years depends on special circumstances such as time, money, demand and supply. One of the important financial theories' is the capital asset pricing model which gives the investor individuals or companies the ability to be more realistic in their investments by taking market risk into consideration. This paper will explain what the capital asset pricing model is, then it will descript the CAPM theoretical underpinning and it will conclude with evaluating the CAPM.
Firstly, portfolio theory has become an essential strategy in the modern investment market. In general, according to Elton (2011), it is a common situation that each person may possess a portfolio which is combined with real assets such as a vehicle or a house, including financial assets such as stocks
MPT is defined, according to investorwords.com (2005), as an overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially measured by alpha, beta, and R². MPT utilizes several basic statistical measures to develop a portfolio plan (Gitman, et al, 2005). Included are expected returns and standard deviations of returns for both securities and portfolios, and the correlation between returns (Gitman, et al, 2005). Detailing the mathematics of diversification, Markowitz proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics (riskglossary.com, 2006). This theory proposes that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio (investorwords.
In order for CAPM to be valid, numerous assumptions were made by William Sharpe. CAPM assumptions are criticized to be unrealistic when compared to the actual stock market. Although there are several assumptions and implications on CAPM, the three main assumptions were addressed in "Corporate Finance" by Watson & Head (2010). The three assumptions as follows: (1) The market is frictionless, therefore there are no transaction costs, taxes, limitations, or troubles with the invisibility of assets.; (2) All investors myopic and own diversified portfolios with a single-period transaction range; (3) Investments are confined to openly traded assets where investors are allowed to borrow and lend unlimitedly at a risk-free rate. In this assumption, assets such as human capital are not included as part of the investment opportunity set. The first major hypotheses of the CAPM is its assumption that the markets are frictionless with no transaction costs, thus assuming that trading requires zero expenditure and investments are valued to drop on the capital exchange line. In reality, investments include activity such as the acquisition of a business or another organization, which involves a large volume of transaction costs. Moreover, under CAPM, investment trading is tax-free and interests