Essay Example on the Capital Asset Pricing Model (CAPM): Measuring the Cost of Risk

Introduction

The Capital Asset Pricing Model (CAPM) is a financial technique that is used to determine theoretically appropriate cost of capital, or required rate of return of an asset, given a particular level of risk. John Lintner and William Sharpe, according to Elbannan (2014), introduced CAPM, building it on the earlier work of Harry Markowitz in 1964. Fischer Black, William Sharpe, and John Lintner further improved the model in the early 1970s, making it a reliable technique for measuring the cost of equity financing (Elbannan, 2014). CAPM is an essential tool in finance because it offers a theoretical relationship between the rate of return and the risk of portfolios, which is the basis of making critical-investment decisions in a firm.

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According to the CAPM, the business risk in a given industry can be categorized into two, namely, unsystematic and systematic risks (Al-Afeef, 2017). The latter refers to the risk that affects all corporations in the market, implying that profitability and share price of all companies in an industry will be moving towards one direction. Examples of systematic risks are a power crisis in the economy, inflation, and political instability. Other factors are an increase in the rate of corporate tax and natural calamities such as earthquakes and floods. This element is also called diversifiable risk, and it is measured in terms of beta factor. (Al-Afeef, 2017). Unsystematic risk, on the other hand, affects only one company in the industry. Unique factors for a business enterprise cause this risk. Some of them are the collapse of marketing or advertising strategies and labor strikes among employees of a firm. This risk leads to unsystematic trends in the firm's profitability relative to the performance in the industry. CAPM, nonetheless, is only concerned with systematic risks. A beta factor of each investment, according to this model, has a significant influence on the discounting rate or required rate of return.

Applications of CAPM

CAPM is used to assess the risk of different investments in portfolio construction. Investors use the beta factor to determine the sensitivity of stock or any other security to the price movements. The beta factor of equity is measured against the referenced market index to evaluate whether a stock is more or less volatile than the market. In portfolio construction, managers use the zero beta model to measure the amount of risk that different securities will add to the firm's portfolio. A beta factor whose value is greater than one implies that equity is riskier than the market (Elbannan, 2014). Under CAPM, stock, or any security that has a beta factor of less than one, suggests that it will reduce the risk of the portfolio. Companies, in this perspective, can apply the concept of CAPM to construct portfolios that have zero systematic risks.

CAPM is used in security valuation to determine the value of financial assets. In determining the expected rate of return for various stock options, the beta of a specific security is multiplied by the market risk premium, which in turn gives an investor the value of an asset. The market risk premium, in this regard, refers to the discount rate or returns that investors expect from the market above the risk-free rate (Fama & French, 2004). The rate obtained is added to the product of the market risk premium and the beta factor of stock. The result gives investors a discount rate or required return, which, in turn, is used to determine the value of an asset. CAPM recognizes that investors expect to be compensated for the risk of investing in a company's stock and also for the cost that underpins the time value of money.

The model is used to determine whether financial securities, such as stock, are reasonably valued. Investors arrive at this decision by comparing the time value of money and the risk of an asset relative to its expected returns. This application of CAPM is critical, especially in evaluating the required return on risky investments. Consumption-based CAPM, in particular, enables decision-makers to assess returns from the stock market relative to the growth of a financial instrument. The higher the consumption beta, the higher the expected gains from risky investments. A consumption beta of 2.0, for example, suggests that there would be an increase in expected returns by 2% if the market grows by 1%. This correlation applies to stock options since companies issue them at a stated fixed charge or discount change. So, their price correlates with market movements. For restricted stock, however, the beta does not reflect changes in the market. Restricted stock has a positive beta because they have low risk and, more importantly, are not fully transferable to other parties until the holders meet specific conditions.

Comparative Analysis of Using CAPM and Arbitrage Pricing Theory (APT)

APT, according to Dhankar and Singh (2005), has been proposed as an alternative to CPAM, which assumes that systematic risk can be eliminated through a properly-constituted portfolio. Both APT and CAPM are essential techniques used to determine the theoretical rate of return on investments or portfolio. While the two models have some similarities, they also have significant differences, implying that there are several benefits and risks for using them.

A key difference between the two models is that CAPM has only one beta and one factor, while APT has several of them. Arbitrage Pricing Theory, to be specific, includes non-company elements which require the beta of the stock relative to each separate factor. This phenomenon implies that APT is more reliable and informative in the long run. The model provides investors with vast information that explains sources of risks and movements in stock prices, among other changes. Using CAPM, on the other hand, tends to be less accurate in the long-run because it considers limited sources of risks. Unlike APT, which focuses on risks that arise from both within and outside the company, CAPM only utilizes systematic risks.

CAPM focuses on assets, while APT is concerned with risk factors that affect the rate of return. The effect is that an investor using APT does not necessarily need to establish an equivalent portfolio to assess risk. This aspect makes APT simpler to use, unlike CAPM, which requires one to quantify returns from a portfolio of a company's assets. However, calculating the discounting rate using APT requires a user to assess multiple factors to determine the level of risk, unlike using CAPM, where a person merely computes the expected theoretical interest rate.

CAPM, according to Alshomaly and Masa'deh (2018), assumes that returns from financial instruments are evenly distributed. Conversely, APT recognizes that there are unanticipated changes that affect the distribution of returns. So, there is a high risk using the CAPM method because the assumption that unforeseen risks cannot occur is unrealistic. APT, on the other hand, is a more beneficial technique because its formula provides for the adjustment of unanticipated changes. This aspect suggests that APT enables investors to identify arbitrage opportunities by finding securities that are mispriced as a result of limited information.

From the analysis of the differences between the two pricing techniques, it is apparent that APT is more beneficial than CAPM. The reason is that it is more accurate, allows for more sources of risks, and also enables the user to consider unanticipated risks. Since APT allows for more sources of risks, it allows investors to make informed decisions by considering both systematic and unsystematic risks. The two methods also have similarities. Both assume that investors cannot influence the price of securities because capital markets are perfectly competitive (Alshomaly & Masa'deh, 2018). Under the two techniques, too, investors prefer more returns to less wealth with certainty. Besides, there are no transaction costs, such as taxes in both approaches, and investors are always risk-averse.

References

Al-Afeef, M. A. (2017). Capital Asset Pricing Model, Theory and Practice: Evidence from the

USA (2009-2016). International Journal of Business and Management, 12(8), 182. doi:10.5539/ijbm.v12n8p182

Alshomaly, I., & Masa'deh, R. (2018). The Capital Assets Pricing Model & Arbitrage Pricing

Theory: Properties and Applications in Jordan. Modern Applied Science, 12(11), 330. doi:10.5539/mas.v12n11p330

Dhankar, R. S., & Singh, R. (2005). Arbitrage Pricing Theory and Intertemporal Capital Asset

Pricing Model. (2012). Security Analysis, Portfolio Management, and Financial Derivatives, 469-511. doi: 10.1142/9789814343589_0013

Elbannan, M. A. (2014). The Capital Asset Pricing Model: An Overview of the Theory. International Journal of Economics and Finance, 7(1), 216-228. doi:10.5539/ijef.v7n1p216

Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46. doi: 10.1257/0895330042162430