Corporate Financial Management : Asset Pricing Model

Part A:-

Part B:-

C:- Details of Capital Asset Pricing Model (CAPM):-

Capital Asset Pricing Model is one of the most widely-accepted methods, used by the investors and financial analysts to estimate the future returns of any specific security or portfolio of various investment policies. The method was introduced and developed by Jack Treynor, William Sharpe, John Linter and Jan Mossin, on the basis of the diversification and modern portfolio theory of Harry Markowitz.

CAPM uses beta, which relates the systematic risk of the security or portfolio with its return to forecast the future return of the security or portfolio (Zabarankin 2014). Thus, the model correlates the risk and return of the individual security or portfolio with the market risk and return accordingly. The formula for calculating expected rate of return under the method is as follows:

E_r = r_f + β (r_f – r_m)

Where, r_f= Risk Free Return

            β = Beta of the stock or portfolio

            r_m = Market Return

The risk free return is the return, provided by such investments, which do not get affected by any type of market fluctuation or economic crisis and can provide returns at same rate over the longer period. In general, the long-term government bonds are considered as the risk free investments.

Beta is the metric, used to measure the volatility level of any individual security or portfolio in relation to the respective market. It defines how the security return would react for any change in the security market. Thus, it represents the effect of the systematic risk of the stock or portfolio.

Market return is the annual return of the security return, in which the stock belongs. The annual return rate of the stock index market, in which the individual stock is invested in, is considered as the market return generally (Ai et al. 2013).

Criticism of CAPM:-

CAPM is the most revered model, used worldwide for evaluating the potentiality of any investment. However, it has also faced several criticisms for many issues. The most discussed drawback of the model is the dependency on the single factor for estimating the expected return. The model uses to focus on the beta, which defines the riskiness of the stock in relation to the market changes. Thus, the forecasted outcome of the model is highly dependent on the relationship between the systematic risk and return of the stock or portfolio.

Many of the researchers and analysts have criticized the over dependency on the single factor for estimating the return. It has been observed that the return of any stock or portfolio does not rely only on the overall market returns. The difference in the volumes of the stocks also affects the expected return.  The proportion of the small cap stocks and large cap stocks does not remain same in all forms of market indexes. Therefore, the slight change of the stock group, which has proportion in the total market index, creates high impact on the overall market return, whereas, the change of the stock group with lower proportion cannot affect the market so highly. Therefore, it is necessary to determine different betas for the two different groups, as the volatility level of the different groups cannot be same due to the differences in the proportion (Dempsey 2013).

Alternative Models:-

Many researchers have tried to improve the CAPM model, by adding more elements in the model. Fama-Fench Three Factor Model and Carhart Four Factor Model are the most appreciated and popular models amongst various improvised versions of CAPM.

Fama-Fench Model includes the size premium as additional aspect for projecting expected stock return. Along with the size premium, it also considers various other prospects for estimating the returns with more realistic approach. The formula of Fama-Fench Model is provided below:

E_r = r_f + β₃(k_m- r_f) + b_s x SMB + b_v x HML

Where, r_f= Risk Free Return

            β₃ = Beta Market

            k_m = Market Return

            b_s = Beta Size

SMB = Small Market CAP, minus, big

b_v= Beta Volume

HML = High book-to-market ratio, minus, low

It is clear from the formula that this revised form of CAPM is based on other factor along with the beta of the market. The incorporation of beta size and beta value has helped the model to reflect the impact of the market size and market volume on the expected return. Thus, it can correlate the stock returns with the systematic risk along with the size premium (Fama 2014).

Carharts Four Factor Model is another improvised asset-pricing model, based on the CAPM and Fama-Fench Model. It has incorporated an additional factor, referred as momentum factor. This factor helps to describe the monthly trend of the market price and the stock price and estimates the stock return accordingly. The formula of the four-factor model is described below:

E_r = r_f + β₃(k_m- r_f) + b_s x SMB + b_v x HML + b_m x UMD

The additional factor, added in this model, is the UMD. UMD can be defined as the zero-cost portfolio premium on winners, minus, losers (Rath and Durand 2015).

References & Bibliography:-

Ai, H., Croce, M.M. and Li, K., 2013. Toward a quantitative general equilibrium asset pricing model with intangible capital. Review of Financial Studies, 26(2), pp.491-530

BiermanJr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge

Dempsey, M., 2013. The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49(S1), pp.7-23

Fama, E.F., 2014. Two pillars of asset pricing. The American Economic Review, 104(6), pp.1467-1485

Rath, S. and Durand, R.B., 2015. Decomposing the size, value and momentum premia of the Fama–French–Carhart four-factor model. Economics Letters, 132, pp.139-141

Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2), pp.508-517