The Capital Asset Pricing Model (CAPM) isn't wrong. It just doesn't go Essay

The Capital Asset Pricing Model (CAPM) isn't wrong. It just doesn't go far enough. Discuss - Essay Example The cpitl sset pricing model (CPM) theory ssumes tht n investor expects yield on certin security equivlent to the risk free rte (sy tht rte chievble on six-month Tresury bills) plus premium bsed on mrket vribility of return X mrket risk premium. In Winter 1991, the mrket risk premium on listed U.S. common stocks ppers to hve been bout 6.5%, ccording to sttistics published in the Qurterly Review, Winter 1991, by the Federl Reserve Bnk of New York (though the Ibbotson study found it to exceed 8% from the mid 1920s through 1987). Thus in period of 4% infltion, the T-bill rte might be ppropritely 4.5 to 5%; four- or five-yer Tresury note should hve yield of 5.5 to 6%; Tresury bonds should yield percent higher thn this; nd corporte bond yields should hve even higher returns to compenste for their dditionl credit or business risk. The cpitl sset pricing model for this scenrio suggests tht nnul returns on low-bet electric utility might be .05 + .50 bet (.065) = 8.25%. bout 75% of this might come from dividends nd the blnce from expected growth in dividends over n extended time period. By contrst, n verge stock with bet of 1.00 should provide rte of return of 4.5 to 5.0% plus the mrket premium of 6.5% or between 11 nd 12%. high-bet stock (one operting in cyclicl industry, for exmple) with bet, or reltive mrket voltility in price, of 1.50 should provide mrket return of 5.0% + 1.50 (0.065) or bout 15%. We could convert these from ernings price rtios to price-ernings (P-E) rtios nd determine tht the electric utilities, in this scenrio, should trde t bout 12 P-E rtio nd the high-bet stock should trde t P-E rtio of bout 6 to 7 . Three-yer verge (smoothed) ernings for these type firms hve, in fct, provided bout these P-E levels for highly cyclicl stocks during recent yers. The problem is in how to evlute bove verge or super growth rte for non- or low-dividend-pying stocks, topic of mjor concern to investment fundmentlists. Since stocks re bought on the bsis of expected returns for the next yer (or for severl yers into the future), perceived shift in the rte of infltion (or of the interest rte level), will send most common stocks to higher or lower levels. Strength of the overll economy, the sector in which the firm opertes, its own industry's strengths nd weknesses, nd individul firm's chrcteristics likewise hve bering on the ssessed mrket vlue of equity issues. In fct, this hypothesis is greed on by most fundmentlists nd technicins. The pproch recommended by most investment fundmentlists moves from the mcro to the micro nlysis. First of ll, we should determine if the overll stock mrket is the plce to be. Next, we should zero in on the industries tht re showing bove-verge strength. Next, we should select individul firms tht re likely to led others in their respective industries. In generl, the security mrket line, t given point in time, ppers to do resonbly efficient job of explining differences in expected yields on lterntive types of finncil issues. The cpitl sset pricing model is merely grph showing the nticipted yields on securities trded in money nd cpitl mrkets with vrying degrees of finncil risk. The trend line tht joins the points on the grph is referred to s the security mrket line. Mrket yields re shown on the y (verticl) xis nd the vribility of return on the x (horizontl) xis.