Question

 

1. Explain in detail CAPM - CAPITAL ASSET PRICING MODEL

• What assumptions are Made in the CAPM Model？
• What is a MULTI- Factor Model

1. What are the potential risks to a business that fails to follow government regulations?

Answer 1

CAPM Model

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

> William F. Sharpe, Jack Treynor, Jan Mossin, and John Lintner independently built upon Harry Markowitz’s ideas on Modern Portfolio Theory and diversification and introduced the capital asset pricing model in the 1960s. Modern Portfolio Theory is a model of investing model in which an investor takes a small amount of market risk to maximize his or her returns in a portfolio.

In 1972, Fischer Black developed a model that does not assume the existence of an asset without risk called the Black CAPM or zero-beta CAPM. This model helped with the general acceptance of CAPM and choosing stocks on the capital market line.

> The formula for calculating the expected return of an asset given its risk is as follows:

ERi ​= Rf​ + βi​ ( ERm​ − Rf​ )

where:

ERi​ = expected return of investment

Rf​ = risk-free rate

βi ​= beta of the investment

( ERm ​− Rf ​) = market risk premium​

> The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in the form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When investing, investors desire a higher risk premium when taking on more risky investments.

The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted average cost of capital (WACC), as CAPM computes the cost of equity.

WACC is used extensively in financial modeling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise value and finally its equity value.

ASSUMPTIONS OF CAPM

1. Risk-averse investors

The investors are basically risk averse and diversification is necessary to reduce their risks.

2. Maximising the utility of terminal wealth

An investor aims at maximizing the utility of his wealth rather than the wealth or return. The term ‘Utility’ describes the differences in individual preferences. Each increment of wealth is enjoyed less than the last as each increment is less important in satisfying the basic needs of the individual. Thus, the diminishing marginal utility is most applicable to wealth.

3. Choice on the basis of risk and return:

Investors make investment decisions on the basis of risk and return. Risk and return are measured by the variance and the mean of the portfolio returns. CAPM assumes that the rational investors put away their diversifiable risk, namely, unsystematic risk. But only the systematic risk remains which varies with the Beta of the security.

4. Similar expectations of risk and return

All investors have similar expectations of risk and return. In other words, all investors’ estimates of risk and return are the same. When the expectations of the investors differ, the estimates of mean and variance lead to different forecasts.

5. Free access to all available information

One of the important assumptions of the CAPM is that investors have free access to all the available information at no cost. Supposing some investors alone are able to have access to special information which is not readily available to all, then the markets would not be regarded efficient. In other words, if the available information has not reached all, it will be difficult to draw a common efficient frontier line.

6. There are no taxes and transaction costs

According to Roll, there must be either a risk free asset or a portfolio of short sold securities. Then only the capital Market Line (CML) will be straight. When there are no risk free assets, the investor could not create a proxy risk free asset. As a result, the capital market line would not be linear and the direct linear relationship between risk and return would not exist.

7. Total availability of assets is fixed and assets are marketable and divisible

This assumption holds the view that the total asset quantity is fixed and all assets are marketable. However, models have been developed to include unmarketable assets which are more complex than the basic CAPM.

MULTI- Factor Model

As used in investments, a factor is a variable or a characteristic with which individual asset returns are correlated. Models using multiple factors are used by asset owners, asset managers, investment consultants, and risk managers for a variety of portfolio construction, portfolio management, risk management, and general analytical purposes. In comparison to single-factor models (typically based on a market risk factor), multifactor models offer increased explanatory power and flexibility.

A multi-factor model is a financial model that employs multiple factors in its calculations to explain market phenomena and/or equilibrium asset prices. The multi-factor model can be used to explain either an individual security or a portfolio of securities. It does so by comparing two or more factors to analyze relationships between variables and the resulting performance.

Multi-factor models can be divided into three categories: macroeconomic models, fundamental models and statistical models. Macroeconomic models compare a security's return to such factors as employment, inflation and interest. Fundamental models analyze the relationship between a security's return and its underlying financials, such as earnings. Statistical models are used to compare the returns of different securities based on the statistical performance of each security in and of itself.

Multi-Factor Model Formula:

Factors are compared using the following formula:

Ri = ai + _i(m) * Rm + _i(1) * F1 + _i(2) * F2 +...+_i(N) * FN + ei

Where:

Ri is the return of security i

Rm is the market return

F(1, 2, 3 ... N) is each of the factors used

_ is the beta with respect to each factor including the market (m)

e is the error term

a is the intercept

Potential risks to a business that fails to follow government regulations

Risk – by definition – is the uncertainty of the outcome of a certain event. Businesses are faced with a variety of risks on a daily basis. Business look to assume the right types of risk with positive consequences, like profit or increased market share, while reducing the potential of negative consequences, like litigation or fines.

When a business does not follow or comply with government regulations, it may experience negative consequences. The government might issue penalties or high fines for noncompliance. Noncompliance may result in a poor public image that lowers the businesss credibility with the public. Customers may stop buying from the business and start buying products from the businesss competitors, resulting in lower sales. Lower sales negatively affect the businesss financial health and may cause the business to file for bankruptcy. If the business is a corporation, noncompliance issues may negatively affect its stock values.

So fines, penalties and bankruptcy are the main potential risks to a business that fails to follow government regulations.