Asset pricing model pdf

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Click here to sign up. Download Free PDF. Imran Hossain. A short summary of this paper. This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula.

The second article, published in the April issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal. CAPM FORMULA Investors hold diversified portfolios following: that there are no taxes or transaction The linear relationship between the return This assumption means that investors will only costs; that perfect information is freely available required on an investment whether in stock require a return for the systematic risk of their to all investors who, as a result, have the same market securities or in business operations portfolios, since unsystematic risk has been expectations; that all investors are risk averse, and its systematic risk is represented by the removed and can be ignored.

A holding period of one year is usually used. While the assumptions made by the CAPM allow The CAPM is often criticised as being unrealistic it to focus on the relationship between return because of the assumptions on which it is based, Perfect capital market and systematic risk, the idealised world created so it is important to be aware of these assumptions This assumption means that all securities are by the assumptions is not the same as the real and the reasons why they are criticised.

The valued correctly and that their returns will plot on world in which investment decisions are made by assumptions are as follows2: to the SML. A perfect capital market requires the companies and individuals.

Even though it can be argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency, there is scope for stock market securities to be priced incorrectly and, as a result, for their returns not to plot on to the SML.

The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because even though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual basis.

The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects the stock market as a whole. Assuming that investors are concerned only with receiving financial compensation for systematic risk seems therefore to be quite reasonable.

A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-free rate for which the yield on short-dated Government debt is taken as a proxy. The reason for this is that the risk associated with individual investors is much higher than that associated with the Government. All investors exhibit homogeneous expectations that the stochastic properties of capital assets return are consistent with a linear structure of K factors.

Either there are no arbitrage opportunities in the capital markets or the capital markets are in competitive equilibrium. The number of securities in the economy is either infinite or so large that the theory of large numbers are applied. The APT hold in both the multi-period and single period cases. Therefore both the theories posses the assumptions of capital market efficiency.

In the case of the CAPM, it considers only single period. On the other hand, the APT considers both multi-period and single period cases. Though consistent with every conceivable prescriptions for the portfolio diversification, no particular portfolio plays a role in the APT Roll and Ross, Unlike the CAPM, there is no requirement that market portfolio on mean variance efficient. Both the theories hold that all investors have homogeneous expectations to maximize their returns.

In case of the APT, the law of large numbers are used for infinite or large number of securities. But in case of the CAPM, it is used for an accurate approximation of the market portfolio. The CAPM is a single factor model: expected return is determined by a single factor systematic risk or beta; whereas the APT is a muli-factor model: expected return is determined by more than one single factor Lumby, For the empirical test of the APT, a variety of factors have emerged as possible determinants of actual common security returns and as statistical tool or method called factor analysis has been used to attempt to identify the relevant factors Emmery and Finnerty, But the APT does not say what the factors are or why they are economically or behaviorally relevant.

However, these factors cannot be identified easily. The APT is derived in a completely different way. However, it looks like to the CAPM, except that it has got multiple beta factors. Instead, factor analysis must be employed to extract the fundamental factors underlying all security returns. The APT states that, if there are sufficient securities, it must be possible to construct a diversified portfolio that has zero senility to each factor.

Such a portfolio would be effectively risk-free and therefore it should offer a zero risk premium. The APT is very similar to the CAPM in the sense that the expected return of any security is equilibrium will be equal to the risk free rate plus a risk premium. Not only that, the APT is similar to the CAPM in the application of the, model that it can be used in exactly the same way as the CAPM for determining the cost of capital, for valuation and for capital budgeting Weston and Copeland, It enables us to estimate the undiversifiable risk of a single asset and compare it with the undiversifiable risk of a well diversified portfolio Weston and Compland, Practical use of the CAPM requires that estimate of beta for securities should be reliable.

It estimates the beta based on historical data are unrelated to actual risk, now or in future, then the CAPM is not a good tool for decision making Weston and Copeland, In case of the CAPM, it is very difficult to estimate an accurate beta, because betas tend to change overtime.

In addition, the CAPM stresses one-dimensional measure of risk beta. Despite the theoretical debate and the difficulty in obtaining accurate betas, some investors use the CAPM, because it systematically relates return with risk and shows how key variables interact Cooley and Roden, In any event, the CAPM provides us with an understanding of the investiors behaviour and market dynamics Cooley and Roden, The CAPM is useful in that it provides several significant views into the major factors of security price determination, and so it is of direct interest of the decision makers within corporations.

Although it involves some unrealistic assumptions and it is not perfect and complete representation of the real would, it is reasonably adequate Lumby, The CAPM may not be perfect, but it does appear to give a reasonable approximation of the world and it does have predictive ability. One of the great advantage of the CAPM is its simplicity. But to test the CAPM two problems arise. Firstly, the CAPM is concerned with expected returns and secondly, the market portfolio should include all risky investment, whereas most of the market indexes contain only a sample of common stocks Brealy and Myers, The study of Roll and Ross claimed that the APT is amenable to empirical testing, in a way that the CAPM is no because i it is not necessary to test the returns on all assets, nor ii there is any special role for the market portfolio.

Other studies e. Both the models state how risky assets are priced in the market equilibrium and they provide decision makers with estimates of required rate of return on risky securities. In spite of their similarities, they differ from various corners in relation to their assumptions, implications, practical use and the like. Therefore, the CAPM is often referred to as a single-factor model. The APT emphasizes the role of the co-variance between asset returns and the exogenous factors, while the CAPM stresses on the co-variance between asset returns and the endogenous market portfolio John Wei, More empirical research is needed in this respect.

Cooly, P. L and Roden, P. Emery, R. D and Finnerty Principles of Finance with Corporate. West Publishing Co. Firth, M and Keane, S.