Risk and return analysis in CAPM Model
With the ramified economic changes, the use of capital assets pricing model has gained momentum throughout the time. Investors have been using the CAPM model the cost of equity of the company. The CAPM model has been used to evaluate the required rate of return of the assets which could be used by investors to choose the particular asset. It is used mainly when there is well-diversified portfolio. This Capital asset pricing model was developed in 1952 with a view to find out the rate of return on the assets and according to that the decision about adding or developing the assets in the business is taken. It helps investors to not only increase the overall return on capital employed but also assist him to accept the one particular project which assists in determining the project option which will give best possible outcomes. This model was faced with many numerous empirical tests, and presences of many more advance assets pricing and selection of portfolio method in the market. But this model carries some of the important and unique feature which makes it very popular that is its simplicity and utility in different situations and circumstances. In 1972 there were different version of CAPM was developed called black CAPM or zero based CAPM Model. This version was very must strong against the empirical testing which leads the organization to use the CAPM worldwide.
The CAPM model is used by organization to give the ranking to the project investment options on the basis required rate of return, the net present value, profitability and internal rate of return. This option is very much beneficial to make the best investment decision. In capital asset pricing model, the pricing of the assets is been done to identity their present values. For instance, if the organization finds out the expected rate of return is less than its cost of capital then the project should not be accepted. They can then analyses the rate of return to the expected rate from return after that the organization can find out whether to invest in this appropriate investment or not. But while going through this process the organization have to make an independent estimate than can be expected from the security in which they are interested to invest this can be done through technical analysis techniques. The technical analysis is made so that investors could choose which option would give best possible return from the possible required rate of return. It is further analyzed that risk and return associated with the investment decision should also be analyzed by the investors while accepting the project. There should be proper equilibrium between the risk and return and by using the CAPM method; investors would accept those project which will give higher return on the basis of the low amount of return.
The risk also come in two forms that are systematic risk also called undiversified risk, and unsystematic risk also called diversified risk. The systematic risk are those risk that are common for all the security that are there in the market, risk will be there equal on all the security. Unsystematic risks are those that are there on the individuals assets. The unsystematic risk can be diversified to the smaller level by the involvement of the great number of assets in the portfolio. But diversification in the systematic risk, it cannot be possible within the one market as whole market is cover with the risk. The CPAM model help to find out the risk that can be transferred and the risk can cannot be transfer so that it becomes easy for the organization to think forward for their business.
Evaluation of the systematic, undiversified risk, and unsystematic risk
As we know with the advantage of many model they carry some of the disadvantage with them the CAPM model as it is cover up with some of the assumptions that decrease its value with a bit in the market, and with the assumption there are some of the problem also that this model carry: The model says that there are no tax or transaction costs, but this cannot be possible in the investment that it doesn’t carry tax or transaction cost so this was the problem for this model although this assumption may be saved from the more complicated versions of this model. CAPM assume that the entire active and the potential shareholders who take part in the day to day activity of the business will consider all the assets but will optimize on portfolio only. But this assumption was properly contradict by the individuals shareholders in the company as human have the habit to move safely, so for these kind of situation also they make multiple portfolio each portfolio for every goal (Fama, & Macbeth, 1973). CAPM model assume that the economic agent will optimize in the short –term of time, according to the fact the long term investor will choose the long –term outlooks instead of the short term of investment as long term investment are more risk free assets for the agent (Graham, & Harvey, 2001), The traditional CAPM use historical data for predicting the future expected return or the expected value, but just on the basis of the historical value, it may become hard to predict the future flow of the business. The future inflow and outflow of cash would be used to determine the required amount of investment. It will be used to strengthen the overall outcomes and by using the discounting factors, investors could determine the present value of the cash inflow and outflow (Lewellen, and Nagel., 2006).
This model content so many problems as this model is based on lots of assumption but still the investor use this model worldwide to calculate the risk that are expected from the investment, the risk that can be diversified and the risk that cannot be diversified to the other person and we can even calculate the coming return from the future investment in short terms and more part of the business depends on the CAPM model (Roll, 1977). If these small problem are removed from this model by revising some of the assumption than no other model can be better than the CAPM model for the investment matter. This model plays a fundamental rule for understanding the price of the determinants goods. Despite from its empirical performance, the investor can think in the different manner about the expected return and the risk from the investor. By understanding this model, investor can think in the different manner to allocate proper return and analyse the facts related to risk and return at all from investment. After analyse of various factors, it could be inferred that capital assets is very imperative tool while making the investment choice or selecting one investment option but it is based on the several assumptions such as risk and return as liner relation if one increase then another will also be increased, it is hard to determine which capital market investment is perfect due to the volatility of the market. The SML and CML both are the two main aspects of the capital assets pricing model which is widely used by investors to gauge the financial performance of the selected securities. The below graph reflects the comparison between the capital (Capital Assets pricing model, 2017).
Problems in the CAPM model
It is analyzed that in CAPM model, capital market line is used to determine to set up trade-off between the risk and return associated with the investment decisions. In case of CML, the above graph depicts the optimum joint point which could be used by company to have equilibrium point between the risk and return of the invested project (Cikaliuk, et al. 2017).
It is analyzed that relation between the risk and return of the selected stocks is determined on the basis of the beta value measured relative to market index. The main critique of the CAPM model in the advanced economy is that investors might face issue while computing the beta value of the investment project. Due to the complexity of the regression analysis, it might mislead investors to compute the beta and required rate of return on the investment project. This beta value computation could be good when CAPM test are best tests of the mean- variances of the undertaken portfolio market proxy. It might impact the accuracy of the investment project which may mislead the investment options (Dahir, Mahat, and Ali, (2018).
It is considered that CAPM model is used to identify the best investment option. When company wants to accept the relation between risk and return in the investment project then it could be done by using the CAPM equation. There is below given CAPM equation which will assist in risk and return of the company (Fard, and Falah, 2015).
The CAPM model relevancy is done to determine the time value of money related to cash inflow and outflow of the project and cost of capital of company. The cost of capital is set on the basis of RF (RISK FREE RATE OF RETURN), beta and market premium (Fernandez, 2015).
There are some realistic and unrealistic assumptions which are considered while evaluating the cost of capital and acceptance of the project (Prezi. 2017). It takes into account all the systematic and un-systematic risk associated with the project which shows the inherent uncertainty and fluctuation in market in the project. By setting up the equilibrium between the risk and return, investors could easily mitigate the risk of un-systematic risk. It is analyzed that investors who want to strengthen their return on capital employed should maximize investment in the particular portfolio to maintain the large location to risky assets. The RF (RISK FREE RATE OF RETURN) is based on the gilt securities, treasury bonds and other risk premium market. Beta should be computed by using the regression analysis on the return of the share capital and market index of the industry. CAPM tests are considered as best tests of the mean-variances efficiency of the portfolio. There are other several models which could also be used by investors to determine the cost of capital and risk associated with the project such as Arbitrage Pricing theory model, Security market line model, dividend discount model and growth model (Yahoo finance, 2018).
Conclusion
CAPM model is useful when it is easy to collect the required data such as beta, risk associated with the investment and return associated with the project. Now, in the end, it could be inferred that CAPM model is used to determine investment option which could be used by investors to determine which option would give him more return if he will invest his capital. The CAPM model covers all the aspects of the investment choices such as return available on investment, risk associated with the proposal and profitability of the project. Investors need to use the particular investment model if he wants to accept the project. The risk and return associated with the project could be analyzed by using the CAPM model and Arbitrage Pricing theory model.
References
Capital Assets pricing model, (2017) Capital Asset Pricing Model (CAPM)? [Online] Available from https://accountingexplained.com/capital/equity-valuation/capital-asset-pricing-model [Accessed on 28th September 2018]
Cikaliuk, M., Erakovic, L., Jackson, B., Noonan, C. and Watson, S., (2017). Board Leadership for Strategic Transformation: Aligning Diversity Initiatives at the Bank of New Zealand. 3(1), pp.21-32.
Dahir, A.M., Mahat, F.B. and Ali, N.A.B., (2018). Funding liquidity risk and bank risk-taking in BRICS countries: An application of system GMM approach. International Journal of Emerging Markets, 13(1), pp.231-248.
Fama, E & Macbeth, J (1973) ‘Risk Return and Equilibrium: Some Empirical Tests’, Journal of Political Economy, 8, 607-636
Fard, H.V. and Falah, A.B., (2015) A New Modified CAPM Model: The Two Beta CAPM. Jurnal UMP Social Sciences and Technology Management 3(1). pp.23-28.
Fernandez, P., (2015) CAPM: an absurd model. Business Valuation Review, 34(1), pp.4-23.
Graham, J &Harvey, C (2001) ‘The Theory and Practice of Corporate Finance: Evidence From The Field’, Journal Of Financial Economics 60, 187-243
Lewellen, J and Nagel (2006) “The conditional CAPM Does not Explain Asset Pricing Anomalies”, The Journal of Financial Economics, 82, (2), 289 – 314.
Prezi. D, (2017) CAPM: Assumptions and Limitations | Securities | Financial Economics [Online] Available from https://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-limitations-securities-financial-economics/29904 [Accessed on 28th September 2018]
Roll, R (1977) ‘A Critique of the Asset Pricing Theory’s Test’, Journal of Financial Economics, 4 (1), 129-176
Yahoo finance, (2018), Online] Available from https://in.finance.yahoo.com/[Accessed on 28th September 2018]
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