Question:
Discuss about arbitrage pricing theory, dividend discount model and disadvantages and alternatives to CAPM.
Answer:
Introduction
Markowitz introduced the concept of CAPM in 1952. CAPM helps to ascertain what will be the investments’ fair value. When computation is done for the rate of return for an asset, the rate is considered to discount the cash flow deriving in future to the PV, hence arriving at the fair value of the investment. It is one of the widely accepted models that help the investors in estimating their return.
Aim
The main goal of CAPM is that the investors need to be compensating in two main ways that contains the time value of money and the element of risk. The time value of money is highlighted by the risk free rate (rf) and the investor needs to be compensated for their contribution over a period of time. The other side of the formula stresses on the risk and assess the compensation the investor require for having enhanced level of risk (Albrecht et.al, 2011). The concept of risk or beta helps in proper determination that enables comparison of the return that will be provided by the asset during a specific period and links to the market premium (Rm-rf).
Objective
CAPM can be defined a strong theory because it leads to evaluation of risk and enables investor to ascertain what they need. It is the best available tool for equity purpose because it helps in evaluation and computation of the potential return. The compensation is provided to the investor in money value and the factor of risk (Davies & Crawford, 2012).
The concept of CAPM states that the expected return of a security equals itself to the rate that is prevalent on a risk-free security in addition to a risk premium. If the expected return cannot beat the required return then the investment must be rejected. The security market line helps in plotting the CAPM results considering all the various risks. Considering the model and the assumptions, computation can be done of the expected return of the stock (Parrino et. al, 2012).
Assumptions
The CAPM provide assumptions that are in directly link to the preferences of the investor where greater return is needed to less and the risk must be compensated accordingly. It also clubs the behaviour of the investor that is the variance of risk in the portfolio and the forecast of the world (Needles, 2011). The assumptions are stated as below:
- Investors look for return that is influence by the factor of risk. Moreover, they are risk-averse that indicates they seek to enhance their wealth considering the opportunities present in the market (Needles, 2011).
- The risk-free rate is the rate at which the investors borrow and lend.
- The market has no disturbance like the cost of transaction, taxes or any kind of restriction in selling.
- The model strives to enhance the economic utilities meaning that the best will happen to the investor. This is due to the fact that all investors aims to enhance their return and the model provides the best platform (Wagenhofer, 2014).
- The results are termed as price takers meaning that they cannot influence the prices. Hence, no control is exercised over prices (Guerard, 2013).
Sums
If the risk free rate stood at 5%, the beta or the measure of risk is 3, expected return stands at 12%, the stock will provide a return 26%
The formula is as:
Risk free rate + Beta *(Expected return – Risk free rate)
(5%+3(12%-5%)
This clearly implies that considering the formula, an investor can determine the rate of return. To compute the expected return, it is needed to have the risk-free rate and the expected return along with the stock beta (Spiceland et. al, 2011).
Arbitrage Pricing Theory (APT)
APT is often viewed as an alternative to the Capital Asset Pricing Model. It is used to calculate the appropriate price of an asset that was incorrectly priced before by describing the relationship between the risk and expected return of securities. The expected return of a security depends upon various macro-economic or security-specific factors like inflation, change in interest rates etc and sensitivity of the securities to these factors. Every security has different sensitivity to these factors; they cannot react to the same parameter always. Hence, a multi-factor model APT is needed because if one can identify a single factor affecting the price, then CAPM would suffice. Any security with a different price from the one that is predicted by APT is considered mispriced and becomes an arbitrage opportunity for the investors or arbitragers (Libby et. al, 2011). They usually try to find these “mispriced” securities and can know that the price of the securities are undervalued or overvalued by applying the Arbitrage Pricing Theory. Hence, this theory is very useful for the investors as their desire for making profits is fulfilled by it.
Consumption Capital Asset Pricing Model (CCAPM)
CAPM relies on market portfolio’s return to predict and understand future price of an asset but CCAPM, an extension of CAPM relies on aggregate consumption i.e. it extends CAPM to include the amount that a company or an individual consumes in the future period. Risky assets create uncertainty in an investor’s property in CAPM whereas in CAPM, these risky assets also create uncertainties in consumption because the wealth of an investor is uncertain because of investing in risky assets. While calculating an investment’s expected return, the CCAPM uses a consumption beta that measures covariance between the ability of an investor to consume goods and services from his investments and return from the market (Graham & Smart, 2012). From the view point of consumers, this model performs poorly as consumers do not take active part in the stock markets and thus the basic link between consumption and return fails but from the view point of corporate world, this model has been used widely as it provides an understanding of relationship between consumption and wealth. It removes some of the weak spots of the CAPM but is criticized after the creation of multi-factor theories like Arbitrage Pricing Theory because it relies upon only one factor i.e. consumption.
Dividend Discount Model (DDM)
DDM is used to calculate the prices of stock with the use of predicted dividends and discounting them back to their present value. In other words, it calculates the value of stocks based on their net present value by using future dividends. The motive behind is that if the value of the stock obtained by this theory is greater than the present value of the shares, then it means the shares are undervalued. CAPM and DDM both are used to estimate the value of securities but their terms of use are very different as CAPM focuses on an entire portfolio for calculating risk and return whereas DDM stay focused on dividend-producing bonds only (Horngren, 2013). CAPM takes into account more factors than only dividends and thus most of the DDM formulas employ CAPM to calculate the net present value. However, to sum up, both CAPM and DDM isn’t a perfect tool as they mostly rely on future assumptions, long-term forecasts are challenging and it is not possible to be accurate in the assumption. Therefore, both DDM and CAPM do potentially provide an estimate of the price of security but in the long run, these tools do not prove beneficial.
Intertemporal Capital Asset Pricing Module
The Intertemporal Capital Asset Pricing Module is a pricing model that is consumption based and gives a return on a security that is expected. Merton provided the concept in 1973. It is merely an enhanced part of CAPM that considers the factors that are time varying. It takes into assumption that the investors will hedge the positions that are risky in nature that are influenced by the factors like inflation, returns in the future, rate of unemployment, etc (Choi & Meek, 2011).
Hence, the portfolio of ICAPM contains the investment that is primary in nature and clubbed to the market. Moreover, it also contains one or more portfolio that can reduce the risk that is foreseen. As every investor contains a risk appetite that varies in nature, therefore the appropriate factor needed to hedge the portfolio will be different (Choi & Meek, 2011). ICAM utilizes an analysis that is based on mean-variance that helps to reach a normal distribution for the consumption risk that stretch over a time span. Moreover, it assumes that there is well defined integration in the international market (William, 2010).
Disadvantages and alternatives to CAPM
CAPM contains many advantages but it is not devoid of disadvantage. The basic disadvantage of CAPM is firstly, that it relies on historic data for predicting future returns that are very far away from reality like betas are being calculated using past data but it may or may not prove to be an appropriate predictor of risk of future returns because they do not remain stable over time. Secondly, it assumes that the expectations and judgments of an investor are the same but if they have varied expectations, they will have different security market line rather than a common SML as implied by the model (Deegan, 2011). Thirdly, while calculating a project specific discount rate, problems may arise in using this model like finding proxy betas are difficult as proxy companies very rarely undertake only one business activity and last but not the least is the assumption in CAPM of borrowing and lending at a risk free rate is actually unattainable i.e. individual investors are not able to borrow or lend at the rate that the government can and thus the minimum required return line might provide lesser return than what the model calculates (Venanci, 2012).
Various other models can be used in place of CAPM as an alternative. As described earlier, one of the alternatives to the CAPM is the Arbitrage Pricing Theory that is a multi-factor model and if one single factor affecting the price could be known, then CAPM would prove beneficial, otherwise not. Next is the Proxy Model in which the economics theory of risk and return are given up and instead, how investments are priced by the markets and relate returns being earned to observable variables are taught (Deegan, 2011). Consumer Capital Asset Pricing Model can also be considered as an alternative to CAPM as it is an extension of the model but is more or less the same and due to its single parameter part, it is neglected like CAPM. A three-factor model was also created and viewed as an alternative to this model (Brigs, 2013). It consisted of three factors namely the market factor, a return on equity factor and an investment factor. This model compares the portfolio to these three risks to assist in better returns. Lastly, is the Accounting information based Models which states that accounting information can also be used as a measure of risk for those who are suspicious of market based measures by estimating a beta from accounting numbers rather than from markets and the best way is to relate accounting earnings of a firm to the accounting earnings for the market (Brigs, 2013).
Conclusion
From the above discussion and study, it can be clearly stated that CAPM is better than any other equation because of the correct forecast made by it. The relationship is framed in a better fashion between the asset risk and the return that is expected. It plays an important role by providing a rate of return that acts as a benchmark for assessing different type of investments. Moreover, it helps in forecasting the expected return on the assets that are not traded yet. It is the most important tool that helps in evaluation of the potential return. The model and application of CAPM makes it popular. It helps in smooth calculation and enables deriving at the return rate. It also considers the systematic risk and that is why it is considered as a potent model and accepted widely (Brealey et. al, 2011). Hence, it can term as a model that leads to strong control and measure. It enables investors in evaluating the risk and return considering the investment and portfolios. However when it comes to some disadvantage it can be said that there are various alternatives too that can be used in place of CAPM.
Reference
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