Capital Asset Pricing Model: The Criticisms and the Status Quo

Transcription

1 Journal of Applied Sciences Research, 7(1): 33-41, 2011 ISSN X This is a refereed journal and all articles are professionally screened and reviewed 33 ORIGINAL ARTICLES Capital Asset Pricing Model: The Criticiss and the Status Quo Abdul Talib Bon. Abdalla Ab Sinusi Faculty of Technology Manageent, Business, Entrepreneurship Universiti Tun Hussein Onn Malaysia, Parit Raja, Johor, Malaysia ABSTRACT Despite the criticiss directed at the capital asset pricing odel, the ethod of this odel and the assuptions underlying it, this odel still reains a powerful tool for analysis. It is used by the specialized agencies in the financial services and anagers to predict the rates of return that are expected to rationalize investent decisions assess financial assets and the cost of capital. That scientific facts state that capital asset pricing odel does not focus on all angles because the risks do not represent the ain reason for the different expected returns. However there are other deterinants that affect the expected returns such as; fir size, rates of diversification, the ipact of the industry, liquidity risk and other paraeters. To conclude, the capital asset pricing odel is designed to estiate the real price of financial assets on the assuption that there is a balance in the arket by acknowledging the relationship between risk and expected rates of return on investent in securities, when used in the portfolios of a good investent diversification. Key words: CAPM, Diversification and Risk, Separation Theory, Optial Portfolio Hazardous, Capital Market Introduction The pricing odel, originally known as the capitalist core econoics of odern finance is he original capital odel which deterines the expected return to copensate for the systeic risk faced by the investor. This odel shows the precise ethod to be observed regarding risk and return of the original as would be expected. It is characterized by capital investent and the financial inability of the investor to deterine the return on investent for identifying the precise investent decision. Although copanies and individuals invest in the light of expectations for the future, different investent returns are expected and required between the investent opportunities, according to degrees of risk associated with each of the., Therefore one ust specify the risk of investing to ake sure that the expected return on investent coensurate with the risk of investent. Characterized by financial arkets as the ost iportant place attracting funds of investors to invest their oney in these arkets, the volue of trading in securities on these arkets was recently increased, propting investors question regarding the relationship between risk and expected return on this investent. Research Background: Capital Asset Pricing Model (CAPM): Capital asset pricing odel based on the idea of equilibriu relationship between returns and risks, Willia Sharpe introduced this odel for the first tie in 1964 to serve as the basis for evaluating investent in securities. Capital asset pricing odel provides us with the iniu level of return, which should be achieved by the investent proposal to copensate the investor for the risks that cannot be avoided, a risk factor easured by beta, reflecting the capital asset pricing odel as shown in the following equation: E Ri Rf i E R R f Corresponding Author: Dr Abdul Talib Bon, Deputy Dean (R&D), Faculty of Technology Manageent, Business and Entrepreneurship. Universiti Tun Hussein Onn Malaysia, Parit Raja, Johor, Malaysia. Tel: Eail: talibon@gail.co.

2 34 Where: E(R i ) Means the expected rate of return on investent R f Mean rate of return risk-free. β i Mean foral risk factor E(R ) Mean arket return The equation of capital asset pricing odel can be explained as follows: Investors expect a return copensating for the utilization of the funds at the present tie, due to directing their oney to investent. This return is copensation to the investor for the tie eleent, so this return is equal to the revenue that the investor can get it if he had invested his oney in areas of uncertain check returns, eaning in risk-free areas (R f ), the investor also expects to get equal additional revenue [E(R )-R f ] to copensate for systeic risk that ay be exposed by the invested oney. This is called return instead of risk. That [E(R )-R f ] is no different than changing the type of investent, because according to the beta, where the beta easure of risk of the regular cannot be avoided as diversification, eaning that the higher the beta goes up the higher the risk (high yield that copensates the investor on the proportion of the risks involved in investent). The lower the beta the lower the risk allowance, eaning that yield of the additional offset investor risk involved is lower in investent, it is clear fro the above equation (R f ) and [E(R )-R f ] they do not change by diversification of investent, so therefore it can be concluded that the beta is the key deterinant of return on investent, in other words that there is a direct relationship between beta and the expected return on investent. Investents which contain a significant risk is beta for a top and the discounted cash flows using the rate of large investents having low risk is beta, of which sall and cash flows are discounted using a sall discount rate. On this basis the expected rate of return on investent for any investent does not change even if the copany has changed the investent, that all the variables in the equation of the for does not change if there is a change in investent. The general risks posed to investent are the general factors affecting all facilities in the sae level of risks. Hypotheses of capital asset pricing odel Capital asset pricing odel based on the following assuptions: (1) That the investor is evaluating the conservative alternative investent on the basis of two variables, return and risk, which Hogan indicates that in order to verify this, the hypothesis ust be a probability distribution of return of noral circulation, eaning that there is a axiu loss equal to 100% of the value of the investent and does not have a liit to profit. This shows that the probability distribution ay be oblique to the right, but this phenoenon does not have an ipact in practice, especially when the revenue forecast period is relatively short. If the control representing onthly return for any stock during the period of tie will be the distribution of this revenue which is distributed norally, in the long ter it is expected that the distribution deviates to the right because there is a axiu of loss and does not have a liit to profit. (2) The assessent of the Securities Investor focuses only on the sae period of tie; this hypothesis provides a better opportunity to assess the return on investent which will be free of risk. (3) That the investor is always trying to achieve better returns if the investor finds an opportunity for investent bankers bargaining chip between the two proposals are identical in all respects except for return, it will choose the alternative that achieves a greater return. (4) That the investor, of course, is not in favor of risk. (5) That the financial assets are indivisible, that the investor can buy any quantity of securities however sall in size. (6) That the investor can lend and borrow on the basis of the rate equal to the rate of return on investent without risk. (7) That there is no tax on profits and the cost of transactions. (8) That the inforation goes up to investors quickly and without cost. (9) There are expectations of siilar and hoogeneous for investors, eaning that the investors have the sae expectation about the expected returns and standard deviation and covariance of the securities traded. This assuption is not far fro the truth, because the ajority of copanies that invests in securities have the sae expectations about returns on investent in such securities.

3 35 Literature review: There are soe doubts about these assuptions in practice, which are rejected by soe due to the inforation on securities available to all investors and that there is unifority on the expectations of return and risk. This eans that investors analyze and understand the inforation on the sae level. The assuptions that the financial arket is an efficient one are difficult to accept. Sharpe (1964) refers to the fact that these assuptions ake the investent in the stock arket as a single unit. Sharpe (1964) also notes that a odel year can be forulate to achieve a balance between returns and risk. This odel can also estiate the expected return to copensate for the risk to yield the return, which is called pricing risk. Paul Krugan (2007) said Milton Friedan suggests that it should not be evaluated on the basis of theoretical assuptions that underpin the, but better to rely on the basis of the evaluation to test the credibility of this theory. Hogan et al (2004) suggests that assuptions that reflect the efficient arket aied at controlling the variables ay affect the for designed to investigate the relationship between expected return and risk and ipact of the risk on the return without the side effects of other variables such as transaction costs and taxes, the exclusion of these variables ay give us a clear relationship between returns and risk. Hogan adds that even if there was a belief that the hypotheses of capital asset pricing odel are unrealistic assuptions, studies aied to deterine the relationship between returns and risk on the basis of the exclusion of these hypotheses, which say that there is no cost or taxes on transactions. The results of these studies conclude that the relationship between returns and risk just like the findings of the capital asset pricing odel. Material and Method Conceptual fraework of the capital asset pricing odel Capital asset pricing odel contains a set of concepts that for the intellectual fraework of the odel as follows: The concept of diversification and risk: Greater diversification in portfolio investent leads to partial reversal of the overall risk. Diversification has its liits; ore diversification does not bring a reduction in overall risk. The risks that cannot be disposed of diversification are called systeic risk, this type of risk is equal to arket risks affecting the securities arket as a whole, these risks are between 25% to 50% of the overall risk of any securities in the arket. The risks that can be disposed of diversification are called the irregular risk or risks viable diversification, this type of risks relates only to securities and not related to other securities which highlights the iportance of naive and siple diversification, as the investor if he had an investent portfolio consisting of 10 or 20 and financial papers, it can reduce a large proportion of the overall risk ay be to 50% of the overall risk in the case of good diversification. Fro the previous view, the researcher says that if the investor can get rid of nonregular risks, it ust be because the arket is not equivalent to incur the risks of possible disposal. The concept of separation theory: The iposition of hoogeneity of investors expectations about the expected returns and standard deviations of the individual s investents and the covariance between the returns on these investents are one of the hypotheses of capital asset pricing odel. The hypothesis shows that, naturally investors do not like risk. It is expected that there is general agreeent aong investors about hazardous optial portfolio which is efficient on a pilgriage in the Markowitz odel. If considering the hypothesis which says that the rate of return on investent without risk, siilar to all investors, the line that coes out fro the point corresponding to the return on investent, risk-free, which lies on the vertical axis, this line will be siilar for all investors. The following forat (5.1) shows the line that coes out fro the point on the vertical axis will correspond to the rate of return on investent without risk, and passes the optial portfolio at M. Since investors agree that the straight line represents the efficient group, the differences on the cobinations they prefer are because of the different ways they view return and risk, eaning that in econoic ters the diversity of both curves for investors. Investors who do not like risks will choose an investent portfolio located on a straight line connecting the risk-free investent portfolio and dangerous as in the Markowitz odel, eaning that the investor will invest a portion of its assets in the portfolio of hazardous and best reaining part of the oney will be Deploying to invest without risk. The venture investor on the risks will choose an investent portfolio located on the sae line, but to the right portfolio of hazardous,

4 36 eaning that the investor will be have a portfolio consisting of investent portfolio as well as dangerous best he can get a loan to increase investent in the portfolio investent hazardous. It is located on the portfolio quality of the ongoing investent, the theory of separation where it says that the portfolio investent which is ade by the investor portfolio and dangerous risk-free investent will be fro the perspective of an investor on the personal return and risk. The relative distribution of resources to individual investents that constitute investent portfolio is not affected by hazardous preferences of investors about the return and risk in Markowitz odel that is supposed to be hoogeneous investor s expectations about the expected returns of individual investents and the standard deviation and covariance of those returns. In econoic ters, there is no effect curve for both the investor to deterine the cobinations that are hazardous optial portfolio, but there are only the effects of rates of dividend portfolio allocations between investent and risk-free portfolio of hazardous optial portfolio, which represents the only efficient reduction in the Markowitz odel. The foregoing suary of whatever difference exists in the expectations of investors regarding risks will have the sae ratio in the individual s investents that is hazardous optial investent portfolio. This conclusion agrees with separation theory, which says that the best allocation of the individual investents that are hazardous optial portfolio will vary according to predicted investor s risk. The concept of optial portfolio hazardous (arket portfolio): The theory of separatis explains that every investor should allocate part of his oney to invest in the portfolio of hazardous optial, which represents part of the Markowitz portfolio-efficient odel, eaning that the point which touches the straight line that coes out of the vertical axis and intersects with the rate of return without risk, which at (M). Figure (5-2) shows that the optial portfolio is hazardous. Under the hypotheses of capital asset pricing odel hazardous optial portfolio can be defined as the investent portfolio, which includes all shares traded in the capital arket. If the shares of a copany do not exist in the optial portfolio, there will be a decline in the deand for the stock and a decrease in its arket value, which leads to high return over investent in this stock, and in turn would lead to an increased deand for this stock to the extent that the stock akes this an optial candidate for the registration of the coponents of the portfolio. Optial investent portfolio that will attract all investors should be huge to provide the needs of all investors, so this investent portfolio contains all securities hazardous in the arket, that the optial investent portfolio should contain all the instruents of investent such as equities, blue-chip stocks, bonds, real estate, gold, currencies and other investent assets, but in ost cases the practice is liited to investent in equities stocks in the financial arket. The portfolio of the arket is iportant to the capital asset pricing odel because the group-efficient portfolio ust include a portfolio arket, eaning that the governor efficient should include investent free of risk (lending) and an additional aount to strengthen the financial resources of the investor and to direct all the savings of the investor to the portfolio the arket (Borrow) The concept of the capital arket line: Capital arket line is the line that reflects the relationship between the systeic risk of the investent portfolio and the expected returns to investent in this portfolio, if ruled out two hypotheses are hypothetical by Markowitz, the efficient group will change to a straight line out fro a point on the vertical axis and passes the optial portfolio. The capital asset pricing odel has not changed anything; a set of efficient portfolios continues to aintain a straight line, but the portfolio, which is illustrated by this line, is the arket portfolio, this line is called a line of efficient group in the capital asset pricing odel, also called the line of the capital arket (CML). It is as shown in the Figure (5.3). As shown in Figure (5.3), the investent portfolios which are ade by the investor do not include portfolio investent and arket risk-free, because they lie below the line of the capital arket. That eans they are not efficient portfolios, except those which lie on the line of the capital arket represented by the point (). In this line, the rate of return on investent free of risk is the sae for all investors and all investors argue for investent in a portfolio of arket. It is known that each point on the line of the capital arket reflects the size of the return and risk of certain investent portfolio. That the volue of return per unit of risk Return on investent Investent Risk This eans that arket pricing for the unity of the risks involved in investing in the investent portfolio. This is the idea underlying the capital asset pricing odel.

5 37 The rate change in D (ΔD) is equal [E(R )-R f ] The rate change in C (ΔC) is equal [σ -0] This eans that the tendency of the straight line which represents the efficient portfolio is the tendency of the capital arket line and is expressed in the following equation: E(R )-R f = line Tendency of the capital arket σ Where: E(R ) Means rate of return on arket portfolio R j Means rate of return on investent without risk σ Means standard deviation of return on arket portfolio So the capital arket line represents the equilibriu relationship between returns and risk for efficient investent portfolios (investent portfolios that are only for systeatic risk), that explains that the capital asset pricing odel provides us with only systeic risk pricing. The Concept of the stocks arket line: The capital asset pricing odel is not only the evaluation of the relationship between returns and risk for only efficient investent portfolios, but also to assess the relationship between returns and risks of individual investents (securities), that the securities are subjected to two types of risks which are systeic risks, the Risk of non-systeic. The investor ust get rid of the Risk of non-systeic by Diversification of investent. According to the capital asset pricing odel, the investor is only copensated for systeatic risks. The risks of securities should be easured by the degree to change the return on these securities with the change of arket return. If there is a balance in the arket, the relationship between the return on investent in securities and risks of investing in securities is the stocks arket line (SML). Where the vertical axis represents the expected return and the horizontal axis represents the systeatic risk easured by Covariance between arket return and the return of the securities. As in the Figure (5.5): To find the tendency of the stocks arket line, the vertical axis ust be selected which is the return and the horizontal axis and represents the risk as in the Figure (5.6): Fig. 5.1: Shows the line of efficient portfollos Fig. 5.2: Shows the oprial portfollos hazardous

6 38 Fig. 5.3: Shows the line of the capital arket (CML) Fig. 5.4: Shows the inclination of the line of the capital arket Fig. 5.5: Shows the stocks arket line Fig. 5.6: Shows the tendency of the stocks arket line Change in the rate of return equals ΔD, where D E R R 2 Change in the rate of risk equals ΔC, where C 0 D E R R So the tendency of the stocks arket line = = 2 C Where: E(R ) Means rate of return on arket portfolio f f

7 39 R j Means rate of return on investent without risks σ 2 Means the arket portfolio return variation That systeic risk of securities is easured by Covariance of these securities, so the forula for capital asset pricing odel is as follows: E R R E R R COV R R Where: E R i f i f, 2 i COV R, R Means expected rate of return on securities i Means the covariance between arket return and return on securities 2 Means the arket portfolio return s variation The previous equation can be rearranged in the following order: COV R, R ER R ER R i i f 2 f COV R, Ri Where the Means the easure of systeic risks 2 i So the final version for capital asset pricing odel will be as follows: E Ri Rf i E R R f If the beta of the securities is biggest than one, this eans that the risk of investing in securities is biggest than investent risk in a portfolio of arket. This eans that the stocks arket line which represents the balance between the expected return and beta is the line which is derived fro capital asset pricing odel. If the stocks arket line shows the balance between the expected return on investent and risk, the capital arket line reveals the balance between the expected return on investent and risk. Discussions Testing the capital asset pricing odel The capital asset pricing odel has been considered as a new technology for investent for several years, as characterized by the attraction to highlight the relationship between returns and risk. However studies conducted to test the capital asset pricing odel has concluded that there is a difference in the results concerning the validity of this odel for the application. Soe researchers said that the scientific evidence requires a rejection of the odel in spite of the clear relationship between the odels achieved by the risks and expected returns. Others said that it is difficult to explain the difference between the study s findings and iplications of capital asset pricing odel, and cannot return the difference to the studies theselves or that the capital asset pricing odel is a siple approxiate odel of the real arket. Fro the above, it can be deduced that the ain proble in testing capital asset pricing odel lies in two ain pillars: (i) The capital asset pricing odel focuses on the expected returns, while the tests conducted focus on the actual returns. (ii) According to the capital asset pricing odel the arket portfolio should include all risky assets available in the arket, but ost of the evidence that the arket contains is only a saple of ordinary shares. Aspects to test the capital asset pricing odel (i) Capital asset pricing odel is based on the four ajor aspects as follows: Test the intersection of the capital arket line with the vertical axis.

8 40 (ii) Test the beta factor as a ajor paraeter of return on investent. (iii) Test whether the line of the capital arket is a straight or curved line. (iv) Test the effect of the indicator used in estiating the return on different arket portfolio returns. Critiques of the capital asset pricing odel: There are eight criticis of a capital asset pricing odel. These criticiss are related to the assuptions of the capital asset pricing odel, that such criticis is the reason for the differing views of researchers on the ability of capital asset pricing odel to deterine the relationship between expected returns on investent and risks. These criticiss are as follows: (i) (ii) (iii) (iv) (v) (vi) (vii) Criticis of the capital asset pricing odel on the equality of the interest rate on lending and borrowing. Criticis of the capital asset pricing odel on the ability of investors to lend and borrow at a rate free of risk. Criticis of the capital asset pricing odel to the hoogeneity of investor expectations of return and risk. Criticis of the capital asset pricing odel on the absence of taxes on profits. Criticis of the capital asset pricing odel on the coponents of the arket portfolio (arket portfolio includes all assets that can be invested). Criticis of the capital asset pricing odel on the rate of return on investent is risk-free (this criticis focuses on the ipact of inflation on the rate of return on investent). Criticis of the capital asset pricing odel on the hatred of the investor s risk (this is obvious and it should not be iposed). (viii) Criticis of the capital asset pricing odel on the absence of costs and availability of free arket inforation for all investors. The current position of the capital asset pricing odel: Despite all the criticis addressed to the capital asset pricing odel, the following points ust be ephasized: (i) understanding that the return and risk are linked together positively, investor always asks for additional revenue to justify affordability to additional risks. (ii) During the past three decades, the prevailing idea was that the risk of securities can be easured by the siple probability distribution, but under the capital asset pricing odel, the risk of the original capitalist is easured fro the perspective of the ipact of portfolio investent. This is added the core of the odel providing a good tool to explain the risks and their relationship to returns expected on the investent in capital assets or investent portfolios, as investors focus on systeic risk only. (iii) The capital asset pricing odel reflects the risk and return by a siple way, and represents a ajor step in understanding the pricing of securities in the arket. It can be concluded that the capital asset pricing odel is the real way for the pricing of securities. (iv) Despite those unrealistic assuptions of the capital asset pricing odel, it is still of interest to researchers and econoists to easure the iportant ideas in finance and investent. Conclusions: In practice there is an intensive use of the capital asset pricing odel, which provides users with good style and enough to know the behavior of securities in the arket. The capital asset pricing odel also helps to ake suggestions and realistic attitudes when pathways prices and returns deviate significantly fro the equilibriu. Thus the capital asset pricing odel is a powerful tool for analysis which is also used by the specialized agencies in the financial services and anagers to predict the rates of return expected to rationalize investent decisions and assessent of financial assets and the cost of capital. Scientific facts stating that the capital asset pricing odel do not focus on all angles, because the risks do not represent the ain reason for the different expected returns, but there are other deterinants which affect the expected returns such as; fir size, rates of diversification, the ipact of the industry, liquidity risk and other paraeters. To conclude that the capital asset pricing odel is designed to estiate the real price of financial assets on the assuption that there is a balance in the arket, by acknowledging the relationship between risk and expected rates of return on investent in securities, when used in the portfolios of a good investent diversification.

9 41 References David, E., Allen and Ibarine Bujang, Conditional Beta Capital Asset Pricing Model (CAPM) and Duration Dependence Tests, School of Accounting, Finance and Econoic, Edith Cowan University. Western Australia. Don, U.A.,Galagedera, 1991, Departent of Econoetrics and Business Statistics Monash University, A Review of Capital Asset Pricing Models. Haribhakti Group, Calculating expected return on investent using Capital Asset Pricing Model. Manjunatha, Mangalore University Karnataka, India, Capital Asset Pricing Model: Beta and Size Tests, International Research Journal of Financial and Econoics. Michael, J. Hartley and Gurdip S. Bakshi, Markwitz Models of portfolio: The Inverse proble, Journal of Financial and Econoics. Paul Krugan, "Who Was Milton Friedan?" New York Review of Books., 32(32): 307. Plessis, A.J. du and M. Ward, A note on applying the Markowitz portfolio selection odel as a passive investent strategy on the JSE, Investent Analysts Journal pp: 69. Rawley Thoas, Applying A New Portfolio Risk/Return Measureent Methodology Based on Recent Advances in Quantifying return Distributions and Investor investors Loss. Rosenberg, B., K. Reid and R. Lanstein, Persuasive evidence of arket inefficiency, Journal of Portfolio Manageent, 11: Sharpe, F. Willia, Capital asset prices: A theory of arket equilibriu under conditions of risk, Journal of Finance, 19(3): Sion, G.M., Koo and Ashley Olson, Capital Asset Pricing Model Revisited: Epirical Studies on Beta Risks and Return, University of San Diego. Steve Hogan, Robert Jarrow, Melvyn Teo and Mitch Warachka, Testing arket efficiency using statistical arbitrage with applications to oentu and value strategies. Journal of Financial Econoics, 73: