A STUDY ON CAPM & REALISM OF ITS UNDERLYING ASSUMPTIONS

Adapted from Students Assignment 2011.

Table of Contents

Chapter 1 2 Research Design CAPM : An Introduction

Particulars

Page No. 4 5

(i) (ii)

Assumptions underlying CAPM CAPM tools to make investment decisions - Security Market Line, Efficiency Frontier & Capital Market Line

6 7 9 11

3 4 5 6 7 8

CAPM Assumptions ; A realistic Approach Comparison of Expected Returns using CAPM and Actual Returns, based on Historic Data - and construction of SML for the same Consideration of taxes in CAPM Effect of inclusion of taxes on the SML and comparing with Actual Returns using graphs Findings & Interpretations Bibliography

21 27 28

Research Design
a) Statement of Purpose: The basic assumption behind the CAPM model are Zero taxes and transaction costs, Homogenity, Riskfree borrowing and lending. Since these assumptions are unrealistic, we propose to examine how inclusion of taxes in the model will effect the Security Market Line - a decision making tool. b) Research objectives: To understand the CAPM and related tools(SML/CML). Realistic examination of its assumptions.

Adapted from students assignment 2011.

Page 2

Effect of relaxation of the assumptions on the SML and the change in the nature of the curve.

c) Research methodology: We performed primary as well as secondary research to better understand CAPM and its usefulness in predicting future security returns. We obtained the opinions of stock market traders on the value of CAPM in securities analysis, who guided us in our research. We also extensively studied material available on the internet. This project is a result of all we have understood of the subject from both these sources. d) Research Scope: This research gives an overview of the meaning, techniques and usefulness of CAPM. However, in depth study of possibility of a substitute new model has not been done. Just a few examples have been taken to understand how it works. More important is if it actually is an effective forecast for prices. e) Research limitations

Statistical figures may not be accurate as they are estimated and not released by official sources We've tried to be as extensive in our research as is possible, but, considering that the topic is controversial, there may be information on the topic that is not available in the public domain.

CAPM : An Introduction
The capital asset pricing model (CAPM) is the standard risk-return model used by most academicians and practitioners. The underlying concept of CAPM is that investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable risk is termed as beta, to which expected returns are linked. The objective of the study is to test the validity of this theory in Indian capital market & the stability of this non diversifiable risk (i.e. systematic risk or beta). CAPM describes the relationship between risk and expected return and that is used in the pricing of risky securities. It is based on two parameter portfolio analysis developed by Markowitz (1952). It is the standard risk return model used by most academicians & practitioners. The underlying concept of CAPM is that, investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable variance is termed as beta, to which expected returns are linked. Adapted from students assignment 2011. Page 3

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Assumptions
The set of assumptions employed to develop CAPM can be summarized as follows: I. II. Investors are risk averse & they have a preference for expected return & dislike of risk. Investors make investment decision based on expected rate of return & the variance of the underlying asset return. i.e. assumptions of two-parameter. III. Investors desire to hold a portfolio that lies along the efficient frontier. (The efficient frontier is also known as diversification frontier) IV. V. There is a risk less asset & investors can lend or borrow at that risk free rate. All the investments are perfectly divisible. That is, the fractional shares for any investment can be purchased in any moment. Adapted from students assignment 2011. Page 4

VI.

All the investors have the homogeneous expectations regarding investment horizon or holding period and to forecasted expected return & level of risk on securities. At the same time, there is a complete agreement among investors as to the return distribution for each security & portfolio.

VII.

There are no imperfections in the market that prevent the investors to buying or selling the assets. More importantly, there are no commissions or taxes involved with the security transaction. That means, there are no costs involved in diversification & there is no differential tax treatment of capital gain & ordinary income.

VIII.

There is no uncertainty about expected inflation, or alternatively, all security prices are fully reflect all changes in future inflation expectations.

IX.

Capital market is in equilibrium. That is all the investment decisions have been made & there is no further trading without new information.

CAPM tools to make investment decisions

SECURITY MARKET LINE (SML) The SML will tell us assets required returns, given their level of systematic risk (as measured by beta).We can compare this to the assets expected returns (given our forecasts of future prices and dividends) to identify undervalued assets and create the appropriate trading strategy.
An asset with an expected return greater than its required return from the SML is undervalued; we

should buy it.

An asset with an expected return less than the required return from the SML is overvalued; we

should sell it (or short sell it if were inclined to be aggressive).

An asset with an expected return equal to its required return from the SML is properly valued;

were indifferent between buying and selling it. Example : The following table contains information based on analysts forecasts for three stocks. The risk-free rate is 7 percent and the expected market return is 15 percent. Compute the expected and Adapted from students assignment 2011. Page 5

required return on each stock, determine whether each stock is undervalued, overvalued, or properly valued, and outline an appropriate trading strategy. Stock Price today Stock A Stock B 25 40 27 45 17 E(Price) in 1 year 1.00 2.00 0.49 E(Divid.) in 1 year 1.0 0.8 1.2 SML for stock C
SML
R(k) = 16.6% Rm=15%

Beta

Stock C 15

Answer: Expected and required returns are shown in the figure below:
Expected Return A B C (27 -25 +1) / 25 = 12.0% (45 - 40 + 2) / 40 = 17.5% (17 - 15 + 0.49) / 15 = 16.6% Required Return 0.07 + (1.0) (0.15 0.07) = 15.0% 0.07 + (0.8) (0.15 0.07) = 13.4% 0.07 + (1.2) (0.15 0.07) = 16.6%
Rf = 7%

R(k) = 7% + 1.2[8%] = 16.6% E(k)

A is overvalued. Its expected to earn 12%, but based on its systematic risk it should earn 15%. B is undervalued. Its expected to earn 17.5%, but based on systematic risk it should earn 13.4%. C is properly valued. It is expected to earn 16.6%, & based on systematic risk it should earn 16.6%.

1.0 1.2

Beta

The appropriate trading strategy is: Short sell A, buy B and buy, sell, or ignore C.

EFFICIENCY FRONTIER & CAPITAL MARKET LINE The efficient frontier consists of the set portfolios that has the maximum expected return for a given risk level.

80
For every level of standard deviation along the X axis, the efficient frontier records the portfolio with the highest expected return (e.g. B & D). No investor would choose Portfolio C because portfolio B has a Adapted from students assignment 2011.

70

rn

Page 6

higher expected return for the same level of risk. Asset allocation along the efficiency frontier changes to provide diff risk-return combos. D will correspond to & 70% equity & B 30 % equity. Higher return - higher risk. Capital Market Line (CML): is the line of tangency between the RFR point on the vertical axis and the efficient frontier.
Capital market Line
80 70 60 Rf 50 40 30 20 10 0 M standard deviation M

expected return

Efficiency frontier

The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The portfolio at the point of tangency is the market portfolio. Market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market. The MP is the only risky portfolio anyone would hold and is the only source of risk. As per risk tolerance, all investors choose a combo of risk free asset and market portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).

CAPM Assumptions - A Realistic Approach (Relaxation)

With the data presented thus far regarding efficiency of capital markets, the assumptions of the CAPM can be relaxed on these grounds : The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature

Adapted from students assignment 2011.

Page 7

1. Differential borrowing and lending rates: There is only one risk free rate in the model. This is an unrealistic assumption. Investors cannot borrow and lend at the same rate. Two rates mean 2 CMLs (as shown in the graph below). One implication of differential borrowing and lending rates is that the borrowing portfolio is not as profitable as when it assumed investors could borrow at risk free rate.

E(R)

K F Rb RFR Risk (standard deviation )

2. Heterogeneous expectations : If all investors have different expectations about risk and return, each would have a unique CML and/or SML, and the composite graph would be a band of lines with a breadth determined by the divergence of expectations. The CAPM assumes invests have the same beliefs about expected returns and risks of available investments. But we know that there is massive trading of stocks and bonds by investors with different expectations. 3. Differing planning periods : if one investor uses a one-year planning period and another uses a one-month planning period, then the two investors have different SML. 4. Taxes Exist : Zero taxes. The CAPM assumes investment trading is tax-free and returns are unaffected by taxes. Yet we know this to be false: (1) many investment transactions are subject to capital gains taxes, thus adding transaction costs; (2) taxes reduce expected returns for many investors, thus affecting their pricing of investments; (3) different returns (dividends versus capital gains, taxable versus tax-deferred) are taxed differently, thus inducing investors to choose portfolios with tax-favored assets; (4) different investors (individuals versus pension plans) are taxed differently, thus leading to different pricing of the same assets. 5. Transaction costs Exist: The cost trading the security may offset any potential excess return resulting from the trade securities will plot close to SML but not exactly on it (shown below). Adapted from students assignment 2011. Page 8

Transaction costs also limit diversification, because at some point , the additional cost of diversification would exceed its benefits

E(R)

SML

E(Rm)

E(RFR) or E(Rz) 0.0 1.0 i

6. Non availability of risk free assets : The CAPM assumes the existence of zero-risk securities, of various maturities and sufficient quantities to allow for portfolio risk adjustments. But we know even Treasury bills have various risks.

Comparison of SML & Actual Returns Based on Historic Data

In order to understand the deviation between the returns calculated using CAPM and the actual returns, the following steps have been taken: 1. Five Stocks have been selected from the Nifty 50 for purpose of analysis 2. Construction of SML: a) The variables in the CAPM model were collected as follows : i) ii) iii) Risk Free Rate of Return - This has been obtained using the 10 year Indian government bond yield for the respective periods. Beta - Obtained from the NSE website for the respective periods from archives Estimated Market Rate of Return - This data has been collected from .

b) SML was constructed in the manner described in the previous pages for each period.

Adapted from students assignment 2011.

Page 9

3. Actual Returns are computed on the basis of historic prices (obtained from NSE) using the formula: AR = P1 - P0 P0 For example if Actual Returns for Jan 2008 are being computed: P1 = Market Price of Stock in Jan 2008 P0 = Market Price of Stock in Jan 2007 D1 = Dividend during period Jan 2007-08 Actual returns for the periods are specified next to the respective charts.

Stock 1: Suzlon
Year Risk Free rate 7.72 5.96 7.63 Beta Expected Market Rate of Return (NIFTY) -51.83 71.45 17.24 CAPM Return R(k) -54.8172 106.1597 22.045 Actual Returns -96.806 36.27451 -39.121

Jan-08 Jan-09 Jan-10

1.05 1.53 1.5

Return
20 10 Rf = 7.72 0 -10 -20 -30 -40 Rm = -51.84 -50 R( k ) = -54.81 -60

Jan 2008

1.05

Beta

0.5

1.5

SML

R(k)

Adapted from students assignment 2011.

Page 10

Re turn
120 R( k ) = 106.16 110 100 90 80 70 Rm = 71.45 60 50 40 30 20 10 0

Jan 2009

R(k)

SML

Rf = 5.96

1.53

Beta

0.5

1.5

Return
R(k) = 22.045 24 21

Jan 2010

Year
Rm = 17.24

Risk Free 18 rate

15 12 9 6 3 0

Beta

Expected Market R(k) CAPM Rate of Return Return (NIFTY) R(k) -51.83 -45.28 71.45 51.1481 17.24 15.2219

Actual Returns

Jan-08 Jan-09 Jan-10 Rf = 7.63

7.72 5.96 7.63

0.89 0.69 0.79

SML

-53.2389 79.32199 19.67071

Beta

0.5

1.5

Stock 2: ACC

Adapted from students assignment 2011.

Page 11

Return
20 10 0 -10 -20 -30

Jan 2008

R =7.72 f

0.89

Beta

0.5

1.5 SML

R =-45.28 (k)

-40 -50 -60

R(k)

Rm=-51.84

Return

Jan 2009

Rm=71.45 R(k) =51.15

80 70 60 50 40 30 20

R(k)

SML

Rf =5.9621
Rm=17.2418 R(k) =15.22
15 12 9 6 3
0

Return 10

Jan 2010
0.69 Beta

0.5

1
R(k)

1.5

SML

Rf =7.63

Adapted from students assignment 2011. 0

0.5

0.79

Beta

Page 12

1.5

Stock 3: Bharti Airtel

Year Risk Free rate
7.72 5.96 7.63

Beta

Expected Market Rate of Return (NIFTY)

-51.83 71.45 17.24

CAPM Return R(k)

-45.2877 66.2108 16.5673

Actual Returns
-25.9154 -54.11 9.3230

Jan-08 Jan-09 Jan-10

0.89 0.92 0.93

Return
20 Rf = 7.72 10 0 -10 -20 -30 -40 R( k ) = -45.28 -50 Rm = -51.839 -60

Jan 2008

0.89

Beta

0.5

1.5 SML

R(k)

Adapted from students assignment 2011.

Page 13

Return
80 Rm = 71.45 70 R( k ) = 66.2108 60 50 40 30 20 10 Rf = 5.96 0

Jan 2009

R(k)

SML

0.5

0.92

Beta

1.5

Return
21 Rm = 17.24 18

Jan 2010

15 R( k ) = 16.56 12 9 Rf = 7.63 6 3 0

R(k)

SML

Beta

0.5

0.93

1.5

Stock 4: ITC
Year Risk Free rate 7.72 5.96 7.63 Beta Expected Market Rate of Return (NIFTY) -51.83919271 71.45 17.24 CAPM Return R(k) -30.9935 41.3246 13.4921 Actual Returns -21.1519 46.44125 -30.7418 Page 14

Jan-08 Jan-09 Jan-10

0.65 0.54 0.61

Adapted from students assignment 2011.

Return
20 Rf = 7.72 10 0 -10 -20 -30 R( k ) = -30.99 -40 -50 Rm = -51.84 -60

Jan 2008

0.65

0.5
R(k)

1.5 SML

Beta

Return
80 Rm = 71.45 70 60 50 40 R( k ) = 41.32 30 20 Rf = 5.96 10 0

Jan 2009

R(k)

SML

Return
21 Rm = 17.24 18 15 R( k ) = 13.49 12 9 Rf = 7.63 6 3

0.5Jan 2010 1

0.54

Beta

1.5

R(k)

SML

Adapted from students assignment 2011. 0

0.61

Beta

Page 15

0.5

1.5

Stock 5: Tata Motors

Year Risk Free rate 7.72 5.96 7.63 Beta Expected Market Rate of Return (NIFTY) -51.83 71.45 17.24 CAPM Return R(k) -41. 74.0696 19.4503 Actual Returns 4.835493 378.0882 60.46098

Jan-08 Jan-09 Jan-10

0.83 1.04 1.23

Return
20 Rf = 7.72 10 0 -10 -20 -30 R( k ) = -41.71 Return -40 80 R( k ) = 74.07 -50 70 Rm = -51.84 Rm = 71.45 -60 60
50 40 30 20

Jan 2008

0.83

0.5

1.5 SML

Jan 2009R(k)
R(k) Beta

SML

Adapted from students assignment 2011. Rf = 5.96

0

10

0.5

1.04

Beta

Page 16

1.5

Return
R( k ) = 19.45 21 18 Rm = 17.24 15 12 9 Rf = 7.63 6 3 0

Jan 2010

R(k)

SML

0.5

1.23

Beta

1.5

INTERPRETATION
As is seen in the charts and table above, there is a vast difference between the Expected returns calculated using the Capital Asset Pricing Model (CAPM) and the Actual Returns computed as per historic prices. One must keep in mind that in the 3 year period selected above - there was a global recession, following which the Stock Market Indices also took unpredictable paths.

Adapted from students assignment 2011.

Page 17

When one uses the CAPM, the Rm is calculated on the basis of historic Indices data and is only an estimate - and this variable can drastically change the expected returns as per CAPM. This is because the Beta, being a risk measure, is also calculated using historic Indices data. Thus, the recession can be considered as one of the reasons for variations. However, even allowing a margin for the unusual external factors mentioned above, the disparity is high enough to show that CAPM assumptions are unrealistic and its value as a practical tool must be questioned. Thus, we proceed to examine how considering taxes in the CAPM formula may impact the returns.

Considering Taxes & Transaction Costs In CAPM

On including tax in the CAPM formula as follows : Re = Rf (1-t) + B [Rm (1-t)- Rf(1-t)], The following marginal changes in return are observed:

Year

Risk Free rate (Rf)

Beta Expected Market Rate of Return (NIFTY) (Rm) 1.05 1.53 1.5 0.89 0.92 0.93 0.83 1.04 1.23 0.65 0.54 0.61 0.89

Tax rate

CAPM Return R(k)

CAPM return with taxes (Re)

Actual Returns (AR)

Difference

SUZLON Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 Jan-09 Jan-10 Jan-08 7.72 5.96 7.63 7.72 5.96 7.63 7.72 5.96 7.63 7.72 5.96 7.63 7.72 -51.83 33.99% -54.8172 -36.1848 -96.806 71.45 33.99% 106.1597 70.07602 36.27451 17.24 33.99% 22.045 14.5519 -39.121 BHARTI AIRTEL -51.83 33.99% -45.2877 -29.8944 -25.9154 71.45 33.99% 66.2108 43.70575 -54.11 17.24 33.99% 16.5673 10.93607 9.323097 TATA MOTORS -51.83 33.99% 71.45 33.99% 17.24 33.99% ITC -51.83 33.99% 71.45 33.99% 17.24 33.99% ACC -51.83 33.99% -41.7141 -27.5355 4.835493 74.0696 48.89334 378.0882 19.4503 12.83914 60.46098 -30.9935 -20.4588 -21.1519 41.3246 27.27837 46.44125 13.4921 8.906135 -30.7418 -45.2877 -29.8944 -53.2389 60.6212 33.80151 53.6729 -3.97903 97.81576 1.612978 -32.371 -329.195 -47.6218 0.693112 -19.1629 39.64793 23.34455 Page 18

Adapted from students assignment 2011.

Jan-09 Jan-10

5.96 7.63

0.69 0.79

71.45 33.99% 17.24 33.99%

51.1481 33.76286 79.32199 15.2219 10.04798 19.67071

-45.5591 -9.62273

Thus, we observe that the inclusion of taxes in the formula in the formula makes a marginal difference.

Effect of Inclusion of Taxes on SML & Comparison With Actual Returns

NOTE : R(k) referred to in these charts is the expected returns calculated as per CAPM on inclusion of taxes.

Stock 1 : Suzlon
Return
20 10 Rf = 7.72 0 -10 -20 -30 -40 -50 -60 -70 -80 -90 -100 -110 AR = -96.806 Rm = -51.84 R( k ) = -36.1848

Jan 2008
Beta

0.5

1.05

1.5

SML AR

Return
80 70 60 50 40 30 20 10

Jan 2009
Rm = 71.45 R(k)= 70.07

AR = 36.27451

SML AR

Adapted from students assignment 2011.

Rf = 5.96

1.53

Beta

0.5

1.5

Page 19

Return
21 18 15 12 9 6 3 Rf = 7.63 0 -3 -6 -9 -12 -15 -18 -21 -24 -27 -30 -33 -36 -39 -42

Jan 2010
Rm = 17.24

R(k) =14.5

0.5

1.5

SML AR

AR = -39.121

Beta

Stock 2: Bharti Airtel

Return
20 Rf = 7.72 10 0 -10 -20 -30 -40 -50 -60

Jan 2008

0.89

Beta

0.5

1
AR = --25.9154 -29.8944

1.5

SML AR

Rm = -51.839

Adapted from students assignment 2011.

Page 20

Return
80 70 60 50 40 30 20 10 0 Rf = 5.96 -10 -20 -30 -40 -50 -60 -70

Jan 2009
Rm = 71.45

R(k)= 43.70

Beta
0.92

SML AR

0.5

1
AR = -54.11

1.5

Return
21 18 15 12 9 Rf = 7.63 6

Jan 2010
Rm = 17.24

R(k) = 10.93 AR = 9.32

SML AR

Return 3
20 10 Rf = 7.72

Jan 2008
Beta
AR= 4.83 0.93 0.83

0.5
0.5

1
1

1.5
1.5 SML AR

-10 0 -20 -30 -40

R(k)=-27.5355

Stock 3: Tata Motors

Rm = -51.84

Adapted from students assignment 2011.

-50 -60

Beta

Page 21

Return
400 350 300 250 200 150 100 50 Rf = 5.96 0

Jan 2009

AR = 378.08

SML AR
Rm = 71.45 R(k)= 48.89 1.04

Beta

0
Return
70 60 50 40 30 20

0.5
Jan 2010

1.5

AR=60.46

SML AR
Rm = 17.24

Re turn 10
Rf = 7.63
Rf = 7.72 20

Jan 2008

R( k ) = 19.45 1.23

0
10 0 -10 -20 -30

Beta

0
0

Stock 4 : ITC 0.5 1

0.65

1.5
1.5 SML AR
Page 22

0.5

1
AR = -21.1519 R(k)= -20.4588

Adapted from students assignment 2011.

-50 -60 Rm = -51.84

-40

Beta

Return
80 70 60 50 40 30 20 Rf = 5.96 10 0 AR= 46.44

Jan 2009
Rm = 71.45

SML AR
R(k)=27.27

0.5

0.54

Beta

1.5

Return
20

Jan 2010
Rm = 17.24

10 Rf = 7.63 0 -10 -20 -30 -40 R(k)= 8.90

0.5

0.61

1.5

SML AR

AR = -30.74

Beta

Return
20 10

Jan 2008

Stock 5 : ACC
0.89 Beta

Rf =7.72

-10 -20 -30

0.5

1.5
R(k)=-29.8944

SML AR

Adapted from students assignment 2011.

-50 -60 AR =-53.23

-40

Page 23
Rm=-51.84

Return
90 80 70 60 50 40 30 20

Jan 2009
AR =79.32199

Rm=71.45

SML AR
R(k) =33.76286

Rf =5.96

10 0

0.69

Beta

0
Return
30

0.5
Jan 2010

1.5

20

AR =19.67071

Rm=17.24
10

SML AR

Rf =7.63
0

R (k)=10.04798

0.5

0.79

Beta

1.5

FINDINGS & INTERPRETATIONS

On the premises of data collected, analysed and observed, the Capital Asset Pricing Model proves to be one that can only generate a trendline i.e. the
Adapted from students assignment 2011. Page 24

behaviour of returns at differing degrees of systematic risk. Capital Asset Pricing Model proves to be ineffective with or without taxes. The behaviour of the SML which we set out to study, changes drastically on inclusion of taxes in the model. There is no longer a linear relationship between market return and expected returns as per CAPM. Rather the nature of the curve itself changes to a non - linear curve showing the non - correlation of market returns to forecasted returns on inclusion of taxes. However, even on inclusion of the taxes in the model, the model was ineffective in forecasting the actual returns for the future periods. Many reasons can be attributed to the inadequacy of the model. The uncertainty in market conditions, and hence, difficulty in predicting the expected market return on historic index trends leads to variation between expected and actual returns. Furthermore, even Beta is computed on the basis of past historic data, and there is no reliability that if the market moves a certain percentage points upwards, the stock will also move as a multiple of that movement. Thus, on closer observation, we see that the assumptions of CAPM are not its only weakness, as was assumed at the beginning of the Research project. As a recommendation, we suggest that even if reasonably sound estimate of Market Return can be made, a study in finding an alternative to use of Beta as the measure of risk and measure of correlation to the market be made. A detailed analysis of an alternative to correlate the market and stock be made.

BIBLIOGRAPHY
Adapted from students assignment 2011. Page 25

 www.nseindia.com : to obtain historic indices, stock prices www.tradingeconomics.com : to obtain 10 year Indian government bond yield www.wikipedia.com : to obtain theoretical understanding of CAPM

Adapted from students assignment 2011.

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