FINANCIAL MARKET AND PRODUCT RISK

Financial Market and Product Risk

Financial Market and Product Risk

Introduction

The CAPM model (capital asset pricing model) is a model used for evaluating assets. CAPM is an equilibrium theory for quantifying risk. The theory gives a beta that is displayed by the stock exchange. Whereas, an arbitrage pricing theory is a method that is used for identifying the expected return of securities and the cost of equity. It is commonly known as a general theory for asset pricing that is involved in holding the expected return of any financial asset such as bonds or securities (Litzenberger, 1991, p.37). All these can be modeled into a linear function on the basis of number of macro-economic factors or indices of the theoretical market, in which the sensitivity to changes in each factor is mainly represented by a factor that is known as beta coefficient.

Critical Evaluation of the two theories

The capital asset pricing model (CAPM) and the arbitrage pricing theory (APT) are the two models which have measured the assets potential in generating return or loss . These two models have been able to do calculate the potential profit or loss through scientific method. Both of these theories are based on the efficient market hypothesis, which are also the part of the modern portfolio theory.

The CAPM says that the return on stock is linked to whether the stock price follow the market overall. It is useful because it gives statistical representation of the past risk. Even though past cannot guarantee future but a consistent performer will repeat the same. If we are investing in a company which has stable results over the past ten years, than CAPM is the best predictor (Merton, 1973, p.892).

The APT holds that future returns of any financial assets are based on the beta.It measures the relationship of a stock with the share index. A company with beta of one fully represents the market. If a person is investing in a company where he wants to measure historical share price sensitivity to market fluctuations mostly in bull and bear markets. For e.g. a person is investing in a stock having 1 beta and using the APT model so he would invest in the stock if the market sentiments are positive . The capital asset pricing model is based on several assumptions, which are considered to be unrealistic in the present world. Many of the scholars consider these assumptions to be the main cause of CAPM flaw. Many of its assumptions have been criticized like assuming that there are no transaction costs and the taxes do not exist. The other assumption that is homogenous expectation also seems too flawed, since investors don't hold stock for the same time period and their expectation is also divergent.

Some Researchers have also said that CAPM in terms of expected return is not correct but the multi-factor model is better off in explaining it. This Capital Asset pricing model according to Rolls, it cannot be tested on theories based on ...