Capital Asset Pricing Model importance in financial world

Capital Asset Pricing Model importance in financial world Capital asset pricing model popularly referred to as CAPM has been of great importance in the asset pricing world. There have been wide acceptances as well as strong arguments regarding the validity of the model over the years, with regards to the fundamental assumptions of the model and the practicability of the model (Bodie, Kane and Marcus, 2005). (Bodie, Kane and Marcus, 2005) The capital asset pricing model provides a yardstick rate of return for appraising possible investments. The standard rate of return is a fair return given the risk involved in the investment. The model also helps us make an educated guess as to the expected return on assets that has not yet been traded in the market place. (Bodie, Kane and Marcus 2005) The CAPM assumes that the security market is large and investors are price takers, there are no taxes or transaction costs, all risky assets are publicly traded, investors can borrow and lend any amount at a fixed risk free rate, all investors analyze securities in the same way and share the same economic view about the world. (Bodie, Kane and Marcus 2005) The organisation of this write-up is as follows a detailed introduction of the capital asset pricing model (CAPM), followed by a literate review of the model which goes into an in-depth analysis of the model as regards to its functions, compatibility and suitability as it relates to asset pricing. Finally, in conclusion a capsulation of the defects, modification and significance of CAPM. J.Balvers, 2001 The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of expected returns on securities and other financial assets. It is considered to be an asset pricing model since, for a given exogenous expected payoff, the asset price can be backed out once the expected return is determined. Additionally, the expected return derived within the CAPM or any other asset pricing model may be used to discount future cash flows (J. Balvers, 2001.p.35). Furthermore according to Bodie, Kane and Marcus, 2005, described CAPM as a method suitable for determining required rate of return of an asset. The model is considered as an extension of Markowitzs portfolio theory. It is expressed in a linear relationship between the return required on an investment and its systematic risk. As described below: E [Ra] =RF + ÃŽÂ ²a [E (Rm) RF), Where, E [Ra] is expressed as the required return on financial assets. Rf is the risk-free rate of return, E [Rm] is the expected market return and ÃŽÂ ²a is the measure of risk [Beta]. CAPM advocates; investors need to be rewarded in two ways: firstly for the time value of money and secondly risk associated with the security. The first half of the formula represents risk free return (Rf) that compensates the investors for placing money in any investment over a period of time. The other half of the formula represents [ÃŽÂ ² E(Rm Rf)] risk premium for bearing additional risk. (Hanif and Bhatti 2010) A more graphical and pictorial representation of CAPM is expressed in the Security Market Line (SML); the line shows the most efficient risk and return to an investor. It shows the expected rate of return of an individual security as a function of systematic risk (beta). FIGURE 1: THE SECURITY MARKET LINE Y X Source: Balvers,(2001:41) The Y-intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the market risk premium (Â µm -rf) and reflects the risk return trade off at a given time: SML: E(Â µM) = Rf + ÃŽÂ ²i [E(Â µm)-Rf] The risk expected return relationship is called the security market line (SML).The expected return on security equals the risk free rate plus the risk premium. In CAPM the risk is measured as beta times the expected return on the market minus the risk free rate. The risk premium of a security is a function of the risk premium of the market and varies directly with the level of beta, no measure of non-systematic risk appears in the risk premium, as CAPM assumes that diversification has eliminated it. (Mullins 2000.) LITERATURE REVIEW Beta is the standard CAPM measure of systematic risk, one way to think of beta is that it gauges security volatility relative to the market volatility (Mullins, 2000,p.108). Stock whose beta are greater than 1 has a high level of systematic risk and are very sensitive to the market changes, stock with beta less than 1 has a very low level of systematic risk and less sensitive to market changes, stock whose beta is equal to 1 as an average level of systematic risk, rise and falls at the same percentage as the broad market index. (Mullins, 2000) In a freely competitive financial market described by CAPM, no security can sell for long at a price low enough to yield more than its appropriate return on the SML. The security will be very attractive compared with other securities of similar risk and investors would bid its price up until its expected return fell to the appropriate position on the SML. Conversely, investors would sell off any stock, selling at a price high enough to put its expected return below its appropriate position. The resulting reduction in price would continue until the stocks expected return rose to the level defensible by its systematic risk. (Mullins 2000). On the SML the stocks with low beta will lead to a low risk premium. Despite the stocks high level of total risk, the market would price it to yield a low expected return. In practice such counterintuitive examples are rare, most companies with high total risk also have high betas and vice versa. Though according to CAPM the financial market cares only about systematic risk and price securities such that expected return lie along the SML. (Mullins 2000). One of the major purposes of the Capital asset pricing model is the determinant of the institutional demand for common stock. At the most basic level, institutional demand should be a function of the risk-return attributes of individual stocks. (Hanif and Bhatti 2010). It is mostly used by the finance managers and/or investors in finding the risk of the investment and to predict the expected return of the stock (Jagannathan and Wang, 1993). It is also used to find out the cost of capital, Capital budgeting is used by a firm to note profitable and unprofitable projects. A key variable in any capital budgeting procedure is the cost of capital, also referred to as the opportunity cost of the capital necessary to finance the project. The opportunity cost accounts for time preference as measured by the risk free interest rate and risk. It assumes that relevant risk is systematic risk that can be measured based on the (estimated) beta of the project and the anticipated market excess return. A related application is in regulation. In a case, for instance, where the government fixes the price of a particular service provided by a utility, the administered price depends on providing the utility with a fair return on capital. This fair return is often calculated by applying the CAPM to determine the systematic risk of the utilitys activities and thus obtaining the required return (J. BALVERS, 2001). CAPM is also an effective tool for portfolio return evaluation; it is used to find out how a managed portfolio has performed. This is because higher levels of systematic risk in the portfolio imply higher average returns. In practice it is used to adjust for risk and also differentiate abnormal returns from simply excess returns. (J. BALVERS, 2001) Mullins, 2000 states that CAPM as an idealized theory of financial markets is surrounded by some controversies in that the models assumptions are viewed as clearly unrealistic. But the true test of CAPM is naturally evident in how well it works there have been numerous empirical test of CAPM. Most of these have been examined in the past to determine the extent to which stock returns and betas have corresponded in the manner predicted by the security market line. With few exceptions the major empirical bodies in this field have concluded that betas are not fixed through time. This fact creates difficulty when betas estimated from historical data are used to calculate costs of equity in evaluating future cash flows. Beta which is used as a measure of risk appears to be associated to with past returns, due to the close link between total and systematic risk, distinguishing their effects will be difficult. Under CAPM it is believed that Beta should change has both company fundamentals and capital structure changes in reality. It is also argued that beta estimates from the past are subject to statistical estimation error. The estimate of the future risk free rate and the expected return on the market are also subject to error, although quite alot of research has concentrated on developing methods to reduce the possible error (Mullins, 2000). Reality matches what the CAPM foretell as the relationship between beta and past returns is linear. Also the relationship is positively sloped which implies that high returns are associated with high risk and low returns are associated with low risk (J. BALVERS, 2001) CONCLUSION In conclusion despite CAPM shortcomings in measuring the cost of capital and due to its single period model coupled with its inability to reflect all market information (efficient market hypothesis) (Johnson, Spearin Groenewegen 2006). Speaking of the inability of CAPM to fully capture and reflect a real life situation this can be better explained in the role CAPM plays in efficient market hypothesis (EMH). Basically there are three forms of market the strong form of market efficiency (EMH) in which the market prices reflects all available information which includes both the insider information and forecast information on a real time basis making asymmetry information absent. Though this cannot be totally assured in the two remaining forms of EMH the semi-weak and weak form of efficiency do no justice when it comes reflecting all available information present in the market on a timely basis and a more informed investor can outperform both uninformed investor and the market as a whol e (Z.A. Ozidemir 2008). In line with the above statement (Merton 1987) was of the notion that in reality some investors were better more informed than others to the extent that some less informed investors were not aware of the existence of some opportunities in the capital market. Despite this deficiency some investors still used CAPM to measure asymmetry information that was present in the market by modifying it to take care of the heterogeneous information. Which included the measurement of how asymmetry information influences stock prices and cost of capital (Easley and OHara 2004).An in-depth examination of the model proves that the use of CAPM both in theory and in practice cannot be totally discarded in that it has much to say as regards to the way returns are determined in the financial market as compared to other models. Its key advantage is that it quantifies risk and provides a widely applicable, relatively objective routine for translating risk measured into estimates of an expected return coupl ed with modification of the traditional CAPM contain the impact of changes in expected return distribution (Javed, 2000). Finally a major advantage of CAPM is the objective nature of the estimated cost of equity that the model can yield. CAPM cannot be used in isolation because it necessarily simplifies the world of financial markets. But financial managers can use it to supplement other techniques and their own judgement in their attempts to develop realistic and useful cost of equity calculations (Mullins, 2000).

Case Analysis Swatch Essay

In 1978, when Dr. Ernst Thomke became managing director of ETA, the position of this Swiss flagship industry had changed dramatically. Especially with the presence of a strong competency (Japan and U. S). Macro-environment: (PESTEL Analysis) * Economic: Threat: The market share had fallen from 56% to a mere 20%. Opportunity: The production had grown from 61 million to 320 million pieces and movements annually. Opportunity: the decline of the dollar was not quite as evident. Threat: Market share loss was more pronounced in finished watches (Japan was producing 50. million Electronic watch compared to Switzerland and had 21% of market share on finished watches) Threat: The situation was aggravated by adverse exchange rate movements relative to the U. S Dollar. Swiss watches was more expensive. Summary: The company had a great problem due to the high technologies of competitors, also their watches was more expensive so their market share had decreased. Industry Environment: 5 Forces of M. Porter: Threat of entry: * New entrants in the market of watches: Japan, Hong Kong. * Prices dropped dramatically from 1000/2000 $ in 1970 to merely 20/40 $ by the end of 70’s * In the 80’s, several competitors switched to the more sophisticated analogue models and thus created competition for the Swatch. Intensity of rivalry among existing competitors: Japan held the technological edge and created the new electronic watch to compete with Swatch. Most of the early American digital watch producers had started to withdraw from the watch business * Ebauches entered into direct international competition with Japanese, French, German and Soviet manufacturers. Bargaining power of Suppliers: * Ebauches S. A, of which ETA was part, was the major producer and supplier of watch movements for ASUAG, the main company (the Switzerland’s largest watch corporation). Bargaining power of Buyers: The third world and newly industrialized nations offer a previously unexplored market for Swatch * The Swiss exported movements and unassembled parts to foreign customers * ETA expanded its movements sales beyond its then current customers (Switzerland, France and Germany) to Japan, Hong Kong and Brazil. Substitute Products: * The invention of â€Å"Electronic Watches† by Japan. The new analogue watch designed by Swatch Key Success Factors: * The â€Å"Delirium† project with the objective to create the world’s thinnest analogue quartz movement. * Highly qualified labor, requiring flexibility, quality, and first-class styling at low-cost. The company adopted the strategy of differentiation and low-cost (economies of scale). * The Swiss company had their stronghold in assembly. * ETA and its parent company ASUAG have a long history of high quality watch design and manufacture. * As part of Switzerland’s largest watch company, ETA had the resources to mount a turnaround effort. * ETA claimed more control over its distribution channels and increased authority in formulating its strategy. The Swatch is produced in one single operation, which means that the production costs are lower. Attractive distributor margins and extensive training of the retailers sales personnel combined with innovative advertising ensure the unique positioning of the product. * The Swatch’s innovative design and production technology led to the creation of a low-cost, highly reliable watch; giving ETA a clear competitive advantage. * Strong brand and customer loyalty: †¢ Repositioning into in the fashion market. A wide range of products with different designs across all price points Mission, Goals, Objectives, Social Responsibility and Ethics: Objectives: Price: Quartz-analogue watch, retailing for no more than 50 Franc Suisse * Sales target: 10 million pieces during the first three years. * Manufacturing costs: Initially 15 SFr – less than those of any competitor. At a cumulative volume of 5 million pieces, learning and scale economies would reduce costs to 10 SFr or less. Continued expansion would yield long-term estimated costs per watch of less than 7 SFr. * Quality: High quality, waterproof, shock resistant, no repair possible, battery only replaceable element, all parts standardized, free choice of material, model variations only in dial and hands.

Emotional Expression Online - Free Essay Example

Analysis Of The Article Undocumented Immigrants

Language is essential to every interaction and aspect in human’s everyday lives. Imagine a world without language, everyone will be mute and doesn’t have any connection with each other. Being able to communicate through language with each other forms bonds and that’s what make human different from any animal species. And language gives us a unique and diverse characters to each of us. In the article of Undocumented Immigrants, the writer (Forest) talks about how the uses of language is so important. The main thesis of the article is that the using of stereotypical terms to describe anyone from autistic children to undocumented immigrants are unacceptable, that is why we need to use more appropriate words to describe something. He claims that language is power. The writer is also successful in making the uses of rhetoric by giving us a real life story of Jose Antonio Vargas. Vargas was tired of all the pejorative language used to describe individuals in immigrants communities: â€Å"illegal aliens†. He braved himself to draw attention to the need for just immigration reform, and to insist the uses of language that validates individual’s humanity. The other article which is the Please, Thank You, it talks mainly about how studying language can make one succeed but it can also affects their culture. The majority of people in the world know english as a foreign language, the writer proves it by giving us statistics (logos). Many students in foreign countries that speak english as aShow MoreRelatedSocial And Academic Performance Of Undocumented Mexican Women Essay1014 Words   |  5 PagesI. Definition of Project For my research, I propose a literature analysis of feelings of guilt, anxiety and sense of separation from social inclusion and the family of undocumented Mexican women in contemporary period. 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