CORPORATE FINANCE
(CF)
MODULE CODE: FC30-3
LEVEL 3
CAPITAL ASSET PRICING MODEL
HUMERA MOHAMMAD SHAHID MOHAMMAD SHAFI (2010120)
AYSHA ABDUL AZIZ AL BASRAWI (2010113)
WORDS 2,532
CAPITAL ASSET PRICING MODEL
INTRODUCTION:
When an investor invests in market, he expects high returns with high risk. As an investor it is very difficult to get rid of all the risk, if he expands his investments. They deserve a rate of return that satisfies them for taking on risk. Risk and return are connected to each other. Investors use a model to calculate how much return he will get and how high would be the risk. The model is called CAPM.
CAPM refers to as capital asset pricing model which can be defined as an approach to find out the investment’s risk and return. In other words it calculates the risk of an investment and determines what return on investment they would get. By the help of CAPM, investors could take the risk to which they are capable of. CAPM was originated by financial economist William Sharpe, Jack Treynor and John Linter. This model is based on earlier modern portfolio theory of Harry Markowitz stated by Gibbons, M.R. and Ferson, W., (1985) .Based on the CAPM; there are different types of risk which are classified under two main groups: systematic risk and unsystematic risk.
Jonathan, B.,(1998) has stated that systematic risk refers to fluctuations of returns due to the influence of macroeconomics factors that affects all the organization. Systematic risk includes different kinds of risk which are market risk, interest rate risk and inflation risk.
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Whereas unsystematic risk refers to the fluctuation of returns due to the influence of microeconomic factors that affects only a specific organization. These factors are controlled within an organization and not the whole market. Unsystematic risk includes business risk and financial risk.
The following report provides a discussion on the concept of beta of capital asset pricing model and the relationship between beta and returns. The report also gives a review of the existing literature on the application of CAPM in various markets. It also identifies the factors that determine the beta and the limitations of applying the CAPM. Moreover the report consists of methodology of how the data is collected. It also gives the calculation of returns on monthly data and as well as beta coefficient. Furthermore, an appropriate analysis is given on the basis of the calculation of returns and beta. Finally the report concludes with a brief summary.
LITERATURE REVIEW:
According to Pettit, R.R. and Westerfield, R., (1974) the appeal of CAPM is it gives strong predictions on how risk can be measured as well as the relationship between risk and return. As we know risk and return are interconnected and both are very significant variable changing investment alternatives. There is a possibility that an investment’s certain results will not conflict with the expected results.
Beta is a measure of systematic risk. It is a standardized measure between two variables which is market return and individual security return. Beta is the most important concept of CAPM. In other words beta is a direct relationship of volatility between any one of the asset which have high beta will increase in price greater than the market.
Unknown, (2012) has argued that the relationship between risk and return is a direct relationship. If investors invest more in their investments the return will be more and it will be more risky. It has been perceived if the risk is high the return on investment will also be high. It means that if one element (return) increases automatically other element will also increase (risk).
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Investors are even pleased with the second option if they invest less they would not expect much of return so the level of risk will also decrease. Although the degree of risk is affected from return on investment, investors should be able to fix the proper return for the level of risk.
Bollerslev, T. Engle,R. F. and Wooldridge, J.M., (1988) stated that an investment involves two main principles for entire investors: the amount of return predicted on their investments and the risk that comes with investment. An investor mostly desires to have less risk and more returned from their investments, but in real it is not possible. The higher will be the return, more risky it will be. Thus Perold,A.,(2004) states that the relationship between risk and return is a financial relationship, because on investment it affects the expected return.
Tsopoglou, S., Michailidis, G., Papanastasiou, D. and Mariola, E., (2006) have examined the Capital Asset Pricing Model for some companies in Greek to find out the relationship between risk and return. The authors found out that it doesn’t supports to the theory’s statement that higher risk is linked with higher levels of return. The relationship between beta and return is not linear. The results they’ve obtained were indicating that higher risk that didn’t give high amount of return. The author observed the differences in results were due to differences in the riskiness of the returns on the assets. The model states that beta is the correct measure of the riskiness of an asset. Fama, E.F. and MacBeth. J.D., (1973); supports the theory of positive linear relation between average returns and beta. Different sizes of the firms was the challenge the author faced in testing the theory by Banz, R., (1981) to perceive whether variation in average returns across assets that remained unsolved by beta. “The author concluded that average returns on small firms stocks (with low market values of equity) were higher than the average returns on large firms stocks (with high market values of equity).
This finding has become known as the size effect.”
Problems applying CAPM:-
Goa, V., (2009) has stated there are many problems and concerns about CAPM model as it is used to judge the risk measurement but it is still not justified. In earlier theories it has been said that CAPM considers non-diversifiable market risks as well as the expected return of a risk-free asset. Despite, the CAPM model theory is acknowledged academically, there are some facts prescribing that it’s not much applicable to the theory. As it has been assumed there will be no cost on inflation and transaction cost and paying tax is also not needed it could cause to some failing consequences to assumptions. Due to these kinds of premises, investors mostly desire to minimize the risk and maximize the return for any level of risk. But up to some extent the reactions from the assumptions doesn’t appears to be real. So implementing the CAPM model has been proved difficult as well. Its assumptions have been disapproved because it was impossible for investors in the real world. Naylor, T.H. and Tapon, F., (1982) has said that the values of risk-free rate of return, the return on the market, or the equity risk premium should be assigned for using the capital asset pricing model. Another problem is that beta values are now calculated and available daily for all stock exchange-listed companies, the problem is that the improbability that arises in the expected return value because the value of beta is not constant, but it changes with the time stated by Graham, J. R., Harvey, C. R. (2001).
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METHODOLOGY:
To compare between risk and return in various companies, secondary data has been used. The secondary data of this report was collected from Muscat security market website and journals articles. The sample of this study is 10 companies which are selected from financing sector in Oman and are also listed on Muscat watch in financing sector. These 10 companies include 6 banks and 4 insurance and financing company .The data is collected for a period of 1 year starting from January 2011 to January 2012. The closing price values are taken from Muscat watch on monthly basis and then the formula is used to calculate the returns of each month. The formula which is used to calculate the returns of each company is:
After that beta values is calculated and collected of each company by using the beta formula which is:
Also the other method is used as well which is beta of an asset can be calculated using the following formula:
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The data is collected to compare and contrast between the beta and returns values of 10 companies. It is also collected to determine how high is the risk and returns for a particular company on the basis of monthly data. The secondary data analysis of this study consists of both descriptive and analytical analysis. The study used descriptive statistical which contain average values of beta and returns. Secondly coefficient correlation is also used which helps to know the positive and negative relationship between the two variables. Moreover, the data of this study was analyzed by comparing the beta and returns using the formulas of beta and returns. It helps us to identify the level of risk which a company was aware of and also to find out whether the beta is more than or less than 1. There are some difficulties in arranging data which is it took more time in collecting the secondary data and calculating accurate values of beta and returns of each company.
DATA ANALYSIS:
The table above shows the figures of average returns and beta coefficient of each single company. According to the above table it shows that out of 10 companies, 8 companies have reported negative returns during the study period where as 2 companies which are HBMO and DICS and has resulted positive returns during the study period. The above table also shows that ABOB, BKDB and MFCI had resulted beta value less than 1 but gives more and negative average returns whereas HBMO and DICS gives positive average returns with beta value less than 1. If a beta has a value of 1 then it moves to the same degree as the market, this is resulted in NBOB which has the beta value equal to 1. If beta has a value less than 1 then the stock moves less than the market but if beta has value more than 1 then the stock moves more than the market. If beta is more than 1 then it’ll provide high return with high risk. Similarly, if beta is less than 1 then it will provide less return with less risk.
It is possible that beta can sometimes be negative. When a value of the market increases, the price of the asset decreases is known as negative beta. Whereas a positive beta indicates that if the value of negative beta is greater then it will show the point to which assets fluctuates oppositely to the market. As we know high beta usually gives high returns; so they can be worst performers during market failure. From the above table it clearly shows that out of 10 financial companies, only 5 companies which are BKMB, BKSB, NBOB, OUIS and AAIT reveals that they have the beta value more than 1 which clearly specifies that they have high risk. Whereas, the other 5 companies out of 10 companies which are ABOB, BKDB, HBMO, MFCI and DICS reveals that they have beta values less than 1 that results in lower risk group. This shows that companies who have low risk than less will be the returns and companies who have high risk greater will be the returns.
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After calculating and analyzing the average beta and returns of 10 companies, the study also tends to find the coefficient of correlation for securities in the financing sector. As we already know that beta and return are interconnected, the result of beta and return correlation shows negative. According to the above calculation and findings it stated that for investor beta is not an accurate measure of risk. This was also confirmed by findings of coefficient correlation which showed that there is negative correlation of 0.500974013 between beta and returns.
According to the capital asset pricing model theory, the company with the higher risk will have higher returns and if a company with lower risk than it will have lower returns. We have used descriptive statistics of the 10 chosen companies from the financing sector in Oman which have showed that 5 companies out of 10 recognized beta values more than 1 have given -1.3788 average returns. This implies that it does not apply the capital asset pricing model theory. These 5 companies have failed to deliver higher returns with higher risk as it turned to negative results. This is because these 5 companies have beta value more than 1 gives an average returns of -1.3788 with an average beta value of 1.466 which indicates that these 5 companies with high risk gives very low returns.
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However the remaining 5 companies out of 10 companies from the financing sector has showed that if the beta value is less than 1 then the returns will also be less obtained. The other 5 companies with beta values less than 1 have given -0.80147 average returns with an average beta value of 0.56. This outcome shows that it reflects with the capital asset pricing model theory. This finding reveals that lower the risk lower will be the returns.
Moreover, the finding of the beta and returns values presents that AAIT Company has recorded the highest beta value of 1.94 among the 10 companies with the negative return of -1.314. On the contrary, from the results it has been estimated that MFCI Company has recorded the lowest beta value of 0.19 with negative returns of 0.648. Similarly it is also estimated that BKDB has recorded lowest negative average returns of 2.433 with 0.77 average betas. On the other hand HBMO has recorded highest positive average returns of 0.589 with average beta of 0.42.
CONCLUSION:
This report involves 10 financial companies for comparing the risk and return values to perceive whether it implies on the theory of capital asset pricing model or not. The capital asset pricing model is the theory of relationship between risk which is beta and return. As it has been known from earlier theories that the relationship between risk and return is linear, that means higher will be the risk higher will be the return obtained from an investment. To examine the theory we have chosen financial companies to measure the risk and return. The close values have been taken to evaluate the average of returns. From the results, we have come to acknowledge that the theory applies on the 5 companies out of 10 which have obtained less returns with less risk. On the other hand, remaining five companies are revealing fewer returns with high level of risk. That means it’s proceeding against the theory of capital asset pricing model. As it has been stated in the theory the higher will be the returns, more risky it will be. So it has been recommended based on the results that the five companies which have beta values less than 1 are giving acceptable and satisfied results as the returns obtained will be less will so the risk will also be less. So this theory is applicable which helps the investor to make decisions on investments whether it gives us high return or low return. So capital asset pricing model is useful for investors to measure the risk and return by using beta.
REFERENCE:
1) ACCA global. 2008. CAPM,theory.advantages and disadvantages.[pdf] London. Available at: http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/sa_jj08_head.pdf [Accessed on 25th November 2012] pp.50.
2) Banz, R., 1981. The relationship between returns and market value of common stock. Journal of Financial Economics. Vol.9,pp.3-28.
3) Bollerslev, T. Engle,R. F. and Wooldridge, J.M., 1988. Capital asset pricing model with time-varying covariance. Journal of political economy. University of Chicago. Vol.96.
4) Fama, E.F. and MacBeth. J.D., 1973. Risk, Return, and Equilibrium: Empirical Tests. The Journal of Political Economy. The University of Chicago. Vol. 81, No. 3,pp. 607-636.
5) Gibbons, M.R. and Ferson, W., 1985. Testing asset pricing models with changing expectations and an unobservable market portfolio. Journal of Financial Economics. North-Holland.pp.217-236.
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9) Naylor, T.H. and Tapon, F., 1982. The Capital Asset Pricing Model: An Evaluation of Its Potential as a Strategic Planning Tool. Management Science. USA. Vol. 28, No. 10. pp. 1166-1173.
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12) Tsopoglou, S., Michailidis, G., Papanastasiou, D. and Mariola, E., 2006. Testing the Capital Asset Pricing Model (CAPM): The Case of the Emerging Greek Securities Market. International Research Journal of Finance and Economics. University of Macedonia. Greece. Issue 4.
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