DEPARTMENT OF POSTGRADUATE STUDIES

INDIVIDUAL ASSIGNMENT

PROGRAMME : MSc. In FINANCE AND INVESTMENT

MODULE NAME : CORPORATE FINANCE

MODULE CODE : FIG 09102

FACILITATOR : CPA VICENT LAURIAN

SEMESTER : ONE

STUDENT’S NAME : SULEMAN IDDY NASSORO

REG. No : MFI/DOM001221

ACADEMIC YEAR : 2021/2022

Required:

Substantiate the above statement.

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Introduction
The CAPM is based on Harry Markowitz's portfolio management approach (1959). An investor
chooses a portfolio at time t-1 that yields a stochastic return at time t in Markowitz's model. The
model assumes that investors are risk averse and are solely interested in the mean and variance of
their one-period investment return when choosing between portfolios. As a result, investors favor
"mean-variance-efficient" portfolios, which 1) minimize portfolio return variance while
maximizing expected return given variation, and 2) maximize expected return while minimizing
variance. As a result, the Markowitz technique is frequently referred to as a "mean-variance
model."

In mean-variance-efficient portfolios, the portfolio model gives an algebraic requirement on asset

To find a portfolio that must be mean-variance efficient, Sharpe (1964) and Lintner (1965) add
two crucial assumptions to the Markowitz model. The first assumption is total agreement: investors
agree on the joint distribution of asset returns from t-1 to t based on market clearing asset values
at t -1. And this is the genuine distribution that is, the one from which the returns we use to test
the model are derived. The second assumption is that there is risk-free borrowing and lending,
which is the same for all investors and is unaffected by the quantity borrowed or lent.

Definition of CAPM

The Capital Asset Pricing model (CAPM) is a model that describes the relationship between
Systematic risk and expected return for assets, particularly stock. In finance the Capital Asset
Pricing Model (CAPM) is a model used to determine a theoretically approximate required rate of
return of an asset, to make decisions about adding assets to a well-diversified portfolio. They would
like to have assets with low beta co efficient (i.e.) systematic risk. Investors would opt for high
beta co-efficient only if they provide high rate of return. The capital asset pricing theory helps the
investors to understand the risk and return relationship of securities. It also explains how assets
should be priced in the capital market. In the CAPM theory, the required rate return of an asset is
having a linear relationship with asset’s beta value (i.e.) undiversifiable (or) Systematic risk.

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According to this concept (CAPM) all investors hold only the market portfolio and riskless
securities. The CAPM has been useful in the selection of securities and portfolios. Securities with
higher returns are considered to be undervalued and attractive for buy. The below normal expected
return yielding securities are considered to be overvalued and suitable for sale. Fama (2004)

Although CAPM's assumptions are manifestly unrealistic, it is often necessary to simplify reality
in order to construct usable models. The fundamental test of a model is not just its underlying
assumptions' rationality, but also the model's prescription's validity and utility. Tolerance of
CAPM's assumptions, however fantastical, enables for the development of a tangible, though
idealistic, model of how financial markets perceive risk and convert it to expected return.

Assumptions of CAPM

Investors are cautious about taking risks.

CAPM works with risk-averse investors who do not want to incur the risk but want to maximize
the return on their investments. Diversification is required to give these investors with increased
profits. However, the larger the portfolio’s perceived risk, the greater the return a risk-averse
investor is expecting to compensate for the risk.

When making a decision, take into account the risks and rewards.

Investors analyze their investment decisions in terms of risk and return, according to CAPM. The
return and risk are calculated using the portfolio's variance and mean. CAPM restores rational
investors' rejection of unsystematic or diversifiable risks. Only the systematic risk, which varies
with the security's Beta, is left. When it comes to the use of Beta, investors have a variety of
viewpoints. Some investors use beta alone to assess risk, while others combine beta with return
variance. CAPM enables a variety of effective frontlines because people perceive risk and reward
differently.

Access to all available information is unrestricted.

One of the most important assumptions is that all investors have unrestricted access to all relevant
and available data. The markets are deemed to be inefficient if only a few investors have access to
exclusive information. To put it another way, establishing a common efficient border line is
difficult if the required knowledge is not widely available.

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Risk and return expectations are similar.

Risk and return assumptions are the same for all investors. To put it another way, all investors
expect the same level of risk and reward. The expected mean and variance differ considerably
when expectations differ. As a result, a plethora of effective frontiers are possible. In addition,
each asset's efficient portfolio will be distinct from the others. The price of an item will vary since
different investors have varied tastes.

A risk-free asset exists, and borrowing and lending at the risk-free rate are not regulated.

CAPM assumes the presence of risk-free assets to simplify Markowitz's theory's intricate and
paired covariance. The risk-free asset leads to a curved efficient frontier in the MPT and simplifies
the linear efficient frontier in the CAPM. Investors, on the other hand, would not be concerned
with the features of certain assets. By increasing a percentage of risk-free assets and borrowing the
additional investments at a risk-free rate, the risk can be reduced or increased.

CAPM's Advantages

The Risk Premium

Allows investors to evaluate an investment's risk premium and use it to inform future decisions.
The excess return on an investment over the risk-free rate of return is known as the risk premium.
The risk premium accounts for the systematic risk of an investment. The investment risk premium
is a tool that allows investors and organizations to calculate the worth of a risk. They are taking.
Startups will pay a higher risk premium, whereas established businesses will pay a lesser risk
premium.

Unsystematic Risk Is Removed

The Capital Asset Pricing Model assumes that investors' investment portfolios are well-diversified.
As a result, any unsystematic risk, such as a risk specific to a particular investment or industry, is
eliminated. Furthermore, it restricts investors to only dealing with systemic risks, or hazards that
are not unique to a specific investment or industry, allowing for better decision making.

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Better than the WACC (Weighted Average Capital Cost)

When it comes to valuing investments that have different systemic risks than corporations, the
Capital Asset Pricing Model is a better tool. This distinguishes it from the Weighted Average Cost
of Capital as a tool for valuing investments. Because Weighted Average Cost of Capital
presupposes that the company's systematic risk is comparable to the risk of the investment, this is
the case. It fails when the investment risk is not the same as the company's systemic risk. As a
result, the Capital Asset Pricing Model generates better results in these situations and allows
organizations to make better investment decisions.

Accurate/Precision

The result is valid, even though the Capital Asset Pricing Model makes some assumptions when
assessing an investment's rate of return. When it comes to high-risk investments, this strategy is
more accurate and reliable than other models like the Dividend Discount Model or the Discounted
Cash Flows Model. When evaluating the rate of return on hazardous assets, many professionals
and analysts use the Capital Asset Pricing Model.

The Beta

The Capital Asset Pricing Model accounts for an investment's systematic risk. The Beta coefficient
is a number that is used to calculate the risks associated with an investment. Other models, such
as the Dividend Discount Model (DDM), ignore the risks that come with an investment. As a
result, for riskier investments, the Capital Asset Pricing Model is the most effective tool. The beta
coefficient is a measure of the systematic risk or volatility of an investment. The beta coefficient
of an investment is usually greater than or equal to one. When the beta coefficient of an investment
equals one, it means that its systematic risk is the same as the markets. Any changes in the
investment's value are directly linked to market fluctuations. If the beta coefficient of an
investment is more than one, it means that its systematic risk is higher than the market's average
systematic risk. The beta coefficient can also be used by businesses to compare their systematic
risk to that of the market. This could be used by businesses to entice potential investors.
Furthermore, companies can use the beta coefficient to invest solely in projects that will help them
keep their beta coefficient under control.

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CAPM's disadvantages

Unsystematic Risk Assumption

According to the Capital Asset Pricing Model, investors should have a broad investment portfolio.
For tiny investors who have only invested in one market or who have an undiversified portfolio,
this may not be the case.

Assumption that the market is perfect

The Capital Asset Pricing Model assumes a perfect market when calculating the rate of return on
an investment. A perfect market is one in which investors have unfettered access to all financial
information. A perfect market exists only in theory; in fact, it does not exist.

Borrowing-Related Assumptions

According to the Capital Asset Pricing Model, investors are free to borrow and lend money at a
risk-free rate. Because investors cannot do so in practice, this is an unreasonable premise. The rate
of return on government treasury bills is calculated using the risk-free rate of return. At government
rates, investors are unable to borrow or lend money in the market.

The use of a single period is assumed.

According to the Capital Asset Pricing Model, investors are only interested in rate of return for a
single period. In reality, most investors want to invest in stocks and other items for a longer period
of time, thus this assumption is incorrect.

Return on investment

These returns can be in the form of increased share prices or dividends received from the
investment. The Capital Asset Pricing Model considers the market return when calculating the rate
of return on an investment. Positive market average returns are consistently forecasted by the
model. When the market's average return is negative over a given time period, however, investors
must compensate by looking at long-term market returns. Furthermore, the return on investment
takes into account previous investment data. As a result, any current or future changes in an
investment's market returns are overlooked, potentially leading to errors.

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Conclusions

Sharpe (1964) and Lintner (1965) created a version of the CAPM that has never been empirically
successful. The Black (1972) version of the model, which can support a flatter tradeoff of average
return for market beta, shows some success in early empirical work. However, research in the late
1970s began to find characteristics such as size, various price ratios, and momentum that contribute
to the beta-based explanation of average returns.

The issues are serious enough to rule out most CAPM uses. The Sharpe-Lintner CAPM risk-return
relation, for example, is frequently recommended in finance textbooks for estimating the cost of
equity capital. The prescription is to calculate the cost of equity by combining the market beta of
a stock with the risk-free interest rate and the average market risk premium. In these exercises, the
typical market portfolio consists solely of U.S. common stocks.

However, historical and new empirical evidence suggests that the relationship between beta and
average return is flatter than the Sharpe-Lintner version of the CAPM predicts. As a result, CAPM
cost of equity estimates for high beta companies are too high (compared to historical average
returns), while estimates for low beta stocks are too low (Friend and Blume, 1970). Similarly,
CAPM cost of equity estimates for value stocks with high book-to-market ratios are excessively
low if the high average returns for value stocks (with high book-to-market ratios) imply high
expected returns.

The CAPM is also commonly used to evaluate mutual funds and other professionally managed
portfolios. Jensen (1968) proposed estimating the CAPM time-series regression for a portfolio and
measuring aberrant performance using the intercept (Jensen's alpha).

The issue is that, due to the CAPM's empirical flaws, even passively managed stock portfolios
might achieve abnormal returns if their investing strategies include CAPM-related tilts (Elton,
Gruber, Das and Hlavka, 1993). Even if the fund managers have no exceptional aptitude for
predicting winners, funds that focus on low beta companies, tiny firms, or value stocks will tend
to yield positive abnormal returns relative to the Sharpe-Lintner CAPM projections.

Nonetheless, the CAPM, like Markowitz's (1952, 1959) portfolio model on which it is based, is a
theoretical marvel.

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References

Fama, E.F., French, K.R., (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal

of Economic Perspectives 18, 25–46.

Abdymomunov, A., Morley, J., (2011). Time variation of CAPM betas across market volatility

regimes. Applied Financial Economics 21, 1463–1478.

Dhrymes, P.J., (2017). Portfolio theory: origins, Markowitz and CAPM based selection, in:

Portfolio Construction, Measurement, and Efficiency. Springer, pp. 39–48.

Jagannathan, R., Wang, Z., (1996). The conditional CAPM and the cross-section of expected

returns. The Journal of finance 51, 3–53.

Zhang, L., (2017). The investment CAPM. European Financial Management 23, 545–603.