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.
Todays widely used CAPM model was originally developed by Sharpe (1964) in order to explain how capital markets set share prices. (Pike and Neale) However, was then developed by others such as Harry Markowitz, John Linter and Jack Treynor. In result of research by Sharpe (1964), Litner (1965) and Black (1972) the Capital Asset Pricing Model (CAPM) is that “the relationship between beta and expected returns is linear, exact, and has a slope equal to the expectation of the market
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So this raises the question what is the CAPM model useful for and how effective is it when estimating cost of capital? Scholars such as Perold (2004) have answered this question through testing and analysis, they have found that even if the model does not give us an accurate real world result in estimating todays cost of capital, it can aid us in predicting future investor behaviour. I would agree with this conclusion of CAPM and Perold’s view on its effectiveness when estimating cost of capital and explaining performance of investment portfolios when given incorrect variables. However, on this note I do not argue that CAPM is theoretically incorrect but from a investors point of view it is questionable, scholars such as Levy (2010) have also stated this within their research of CAPM backing up their argument with thorough testing and analysis within his journal ‘The CAPM is alive and …show more content…
They found that APT was not sensitive to the number of risk factors above five, and that the CAPM approach of measuring portfolio investment were more related to average returns without any risk adjustments like APT.
We cannot deny that APT is effectively applicable when explaining performance of investment portfolios, this has been researched and tested by a number of scholars. Most recently Ramadan (2012) carried out a test of validity of APT in the Jordian Stock Market, his findings were that macroeconomic variables as well as market indicators explained 84% of the variation in returns on his chosen market portfolio. Another finding was that the effect of certain variables converse when comparing industries within the market. (Ramadan,
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
Markets can be efficient even if stock prices exhibit greater volatility than it can be explained by fundamentals such as earnings and dividends. Chapter 11: Potshots at the Efficient –Market Theory and Why They Miss, presents an argument of stock market fluctuations that stock prices show far too much variability to be explained by an efficient-market theory of pricing. It also talks about how one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market. I agree with Malkiel’s proclaim about the demise of the efficient-market theory and how it reasons to show that market prices are indeed predictable. Such arguments are exaggerated and the extent to which the stock market is predictable is greatly overstated because market valuation rests on both logical and psychological
(CAPM). Other methods, such as the dividend-discount model (DDM) and the earnings-capitalization ratio, can be used to estimate the cost of equity. In my opinion, however, the CAPM is the superior method.
Applying an “Agile” approach to business – Capital One Bank (case study) Capital One and the need for Agility ➢ Capital One bank employs more than 47 000 people with a revenue reported of $25 billion (2016). ➢ It is a diversified bank that offers a variety of financial products and services to consumers, small businesses and commercial banks. ➢ After launching in the 90s it was one of the smallest banks in America and this aided to their advantage as they were able to react to market demands rather quickly. ➢ On expansion the bank lost some of its agility with delayed processes and out dated systems.
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
This assignment is concerned with your understanding of the key issues relative to portfolio analysis and investment. In completing this assignment you are to limit your scope to the US stock markets only. Use the Cybrary, the Internet, and course resources to write a 2-page essay which you will use with new clients of your financial planning business which addresses the following issues and/or practices:
In turn everything in the present and the future is judged through the stocks as they hold a high importance in industrialized economies showing the healthiness of said countries economy. As investing discourages consumer spending over all decreases, it lead...
The MDA model also showed potential to ease some problems in the selection of securities for a portfolio, but further investigation was recommended.
...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.
Hanif, Muhammad and Dar, Abubakar Javaid, Comparative Testing of Capital Asset Pricing Model (CAPM) and Shari’a Compliant Asset Pricing Model (SCAPM): Evidence from Karachi Stock Exchange - Pakistan (November 18, 2011). 4th South Asian International conference (SAICON-2012), Pearl Contenental Hotel, Bhurban, Pakistan, 05-07 December, 2012. Available at SSRN: http://ssrn.com/abstract=1961660 or http://dx.doi.org/10.2139/ssrn.1961660
Modigliania, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review.
By using the Capital Asset Pricing Model (CAPM), Cohen calculated a Weighted Average Cost of Capital (WACC) of 8.4%.
Following the trend of economy, it is important to investors to understand that strong economy creates strong stock market. To elaborate further, as stock prices are increased by current and future expectations of earnings, thus without a strong economy it would be difficult for the companies to increase and sustain their earnings (Kong 2013). The economy development is usually calculated using the gross domestic product of a countries. On the other hand, a change is the stock price can also cause a major impact to the consumers and investors directly. Hence, a loss in confidence by investors can cause a downturn in consumer spending in the long term, which will also affect the economy’s output (Aysen 2011). The graph below shows the relationship of stock market price (KLCI) and the GDP of Malaysia in 2009. Thus, it can be concluded that the economy and the stock market has a positive relationship.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.