I. CAPM Model
Capital asset pricing model (CAPM) is a model in finance that aims to explain the relationship between expected return and risk and formally represents the tradeoff between risk and return. It stipulates that a return of any portfolio or a security is a sum of the risk free security and a risk premium. This relationship can be expressed through an equation Rm = Rf + β ( Rm – Rf), where
Rf = risk free rate
β = contribution coefficient of the stock to a diversified portfolio
Rm = expected market return.
Here the risk-free rate is a theoretical return that is generated by an investment with zero risk of a loss and is usually proxied by governmental bonds. CAPM was developed by
II. Limitations to the CAPM application
CAPM is based on a number of assumptions that make the model rather rigid and limit its application. Firstly, all investors are risk averse and behave rationally according to the theory and make their portfolio decisions based on the information on the returns. This belief is often unrealistic and does not reflect the complexity of the decision-making process of investors. Research in the area of behavioral finance sheds more light on the bounded rationality of investors.
Secondly, beta calculations in the CAPM make predictions based on historical data, which do not necessarily reflect future conditions. In addition to that, unconditional or constant betas are usually used in valuation, thus disregarding the change of beta over time. Deviation of beta could allow reflecting time-varying risk and has been shown to predict risk-return profiles over time more precisely. Considering these facts, the predictive power of the basic CAPM calculations is strong only in case the assumptions and conditions underlying calculations do not change over time, which is impossible in the real world.
Furthermore, the interests of investors according to CAPM are homogeneous and all investors have access to the same information. CAPM also assumes a perfect market, which is free of the influence by institutions and where there are no transaction costs, restrictions or taxes. Investors here act as price takers and cannot affect market prices. These assumptions represent an idealized view of the market and only reflect the real-world environment to a limited extent. Thus, no market is fully transparent in terms of information. Therefore, market players, who possess more information than others, have an unfair advantage and can generate significantly higher returns than all the other participants. Financial markets, especially international ones, are also characterized by restrictions and taxes, which distort the risk-return relationships described by the CAPM. Exchange rates as well as country premiums in developing countries also distort the straightforward CAPM predictions. Under such conditions political and institutional frameworks may significantly determine betas and/or alter them over time.
There is a controversy also about the empirical evidence of the relationship between stock returns and the market beta. Some studies have shown that there is not necessarily a relationship between these two parameters. Others, on the other hand, found a correlation between market risk and return. However, the slope of the security market line obtained in the studies was too flat and was not sufficient to explain empirical values. Therefore, the market risk parameter, beta, cannot could not fully clarify the relationship between market risk and return. Other factors usually contribute to determining the difference in returns in situations when betas are equal. Thus, for example the so called “size premium” makes the returns of companies with small market capitalization relatively higher. “Value premium” describes the positive relationship between returns and the dependence of market and book values. These and other limitations of the CAPM make the model a poor predictor of the market returns. Therefore, new models are sought by financial scientists and business practitioners in order to describe the relationship between risk and return with more precision and to avoid the limitations of the CAPM. Thus, for example multifactor models are used to improve CAPM predictive model. For example the three-factor model by Fama (1993) links returns to the market size and the value/growth parameters. The three-factor model has been also extended by adding a liquidity parameter, which is inversely related to the portfolio returns. CCAPM (Consumption-based capital asset pricing model) has been developed to complement CAPM and helps to explain how consumption is protected during economic downturns (Kürschner, 2008).
III. The use of CAPM by corporate managers
Corporate managers often use CAPM as the most basic valuation tool. However, its application has some drawbacks, which make it a poor fit for the corporate environment.
Firstly, CAPM application is constrained by its complexity. Thus, in order to evaluate the mixture of financing sources, many companies use same target debt to equity proportions for several years without adjusting the risk and return profiles. This fact hampers the long-term predictive power of the CAPM, especially when used by corporate managers in the dynamic real-world business environment.
In addition to that, CAPM serves best the interests of investors, who try to maximize their returns and are not concerned with company longevity. Corporate managers, on the other hand, have to think about longer-term prospects. Thus, they view risk and return profiles of specific projects in relation to potential synergies with current operations and in the light of future company development. What appears to be a risky stand-alone project, may add value for the overall company and cannot be viewed separately from other activities (Brigham & Houston, 2009).
The assumptions behind CAPM also make the model impractical in the corporate world. Thus, market efficiency or perfect information are the assumptions that never hold true in reality and distort greatly CAPM predictions. That is why corporate managers should be careful when using CAPM.
Despite all the drawbacks, CAPM gives corporate managers a tool to estimate the systematic risk of a specific asset. Since assets with low risk on average offer lower return, CAPM allows making an educated guess about the risk and return profiles of potential investment alternatives. That is why CAPM is widely used by corporate managers as well as by analysts, despite its limited predictive power (Megginson & Smart, 2008).
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Kürschner, M. (2008). Limitations of the capital asset pricing model (CAPM). Scholarly paper, Grin Verlag: Norderstedt, Germany.
Lintner, J. (1965). Valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47(1), 13-37. Megginson, W. L., & Smart, S. B. (2008). Introduction to Corporate Finance. Mason, OH: South-Western Cengage Learning.
Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19 (3), 425-442.
Treynor, J. L. (1962). Toward a Theory of Market Value of Risky Assets. Unpublished manuscript.