Evaluating The Capital Asset Pricing Model In Modern Finance

Stock Return and CAPM Analysis Report

Question one
The paper used three stocks of AGL Energy (AGL), Asciano Limited (AIO), and AMCOR Limited (AMC). Monthly histories of prices for the stocks for 1st October 2009 t0 31st October 2014 listed in ASX

Compute the individual monthly returns, average monthly return, variance and standard deviation of the monthly returns for the stocks of the companies you have chosen.
To compute the return on individual month, the prices of the month and that of the previous month was adjusted. In constructing the table below, the price of the preceding month of the first month is not available in the table. Therefore, the price of the first month was not calculated, and the price for the second month was calculated as r2= = 1 Where p*= adjusted prices incorporating the effects of stock dividends, cash dividends and stock splits. The adjustable prices are readily available from the “DatAnalysis Premium” link in Deakin Online Library.

Solution 1
In computing the return on individual month, I used the formula = 1 in which P*2 is the adjustable closing stock price at beginning of a particular month, P*1 is the adjustable closing stock price at the end of the particular month. I divided the P*2 by P*1 and then subtracted 1. The result was then converted to percentage by multiplying by 100. For example, P*2 of AGL Energy company in 30/09/2014 was 13.49, and on 31/10/2014 P*1 was 13.59. Calculate: – 1= -0.00735835. Converted to percentage =-0.74% as return on individual month. Using Ms Excel and using the formula, it was =C3/C2-1. The same formula was used in calculating return on individual month for all the months from October 2009 to October 2014 for the three companies of AGL Energy (AGL), Asciano Limited (AIO), and AMCOR Limited (AMC) as shown in the embedded Excel document.

Solution 2
In calculating average monthly return, standard deviation and variance, I used Ms Excel software of finding average. In my worksheet, I listed the returns in the following ranges: AGL=C2:C62, AIO=D2:D62, AMC=E2:E62. Therefore the formula of finding average monthly return in excel for AGL was =Average (C2:C62) = 8.01%. The formula for Standard deviation for AGL also was =STDEV (C2:C62) =0.623542. Standard deviation is square root of variance, therefore in calculating variance, I squared the standard deviation figures as shown in the excel embedded below.

b) Using the various statistics calculated in a), state which stock has the highest expected return, which stock has the highest total risk and which one has the highest expected return per unit of total risk.
Highest expected return- AMCOR Limited (AMC) because it has a the lowest standard deviation of 0.1169 making it less volatile.
Highest total risk- AGL Energy because it has the highest standard deviation of 0.6235 making it a volatile stock. According to Hassett (2011), a volatile stock has a higher standard deviation.
Highest expected return per unit of total risk- AGL energy has the highest risk and also the highest expected return. From the computation, its average return from the past 61 months indicate an average of 8.01% which makes the highest expected return stock per unit of the total risk.

c) Would the stock with the highest total risk in b) necessarily be the ‘riskiest’ of the three stocks? Explain
No, as much as AGL energy has the highest risk because of its high value of standard deviation which makes it highly volatile, it has the highest average return of 8.01% compared to Asciano Limited (AIO) of 1.17% and AMCOR Limited (AMC) of -2.48%. From the three companies, the riskiest company in terms of making investments is AMCOR Limited (AMC) since its average return is negative and also the lowest. As much as its historical volatility is the lowest, its average return is not impressive to an investor (Barenblat & Mesler, 2002).

d) Use the month-end adjusted closing values of the AORD to compute individual monthly returns on the market index.
Similar to part (a), I used the formula of = 1 in calculating the individual monthly returns on the market index. The closing value of AORD were also already adjusted. Moreover, applying the same formula in excel, I computed the monthly returns as shown in the attached excel workbook below named “SHARES 2”.

e) Briefly describe the beta estimation process as per the CAPM. Using the information in d) along with the individual monthly returns on each of the three stocks calculated in a), estimate their betas.
CAPM is a model describing the relationship between the expected return and risk and is used in the pricing of the securities that are risky. Beta is a measure of the systematic risk, volatility of a portfolio or a security in comparison to the whole market (Harrington & Harrington, 2007).

The paper used SLOPE method in excel in estimating the beta. For instance, in computing the beta value of AGL Company in relation to AORD market values: =SLOPE (J3:J62, I3:I62) = 0.587251. The estimation of the betas for AORD &AGL=0.587251 and AORD &AIO=0.980865 was less than 1 and greater than zero. For AORD&AMC=-0.06169 which had a negative value indicate a more stable stock prices.

CAPM Calculations:
AGL Energy (AGL): Ra = 3% + 0.587251 (8.01%-3%) = 5.942%
Asciano Limited (AIO): Ra = 3% + 0.980865 (1.17%-3%) = 1.205%
AMCOR Limited (AMC): Ra = 3% + -0.06169 (-2.48%-3%)= 3.338%

Question two
The application of the CAPM in modern financial markets has been much debated and criticized from an empirical point of view. Does this imply that the theory underlying CAPM is flawed? Outline your argument. The essay will argue that the numerous empirical evidence produced against CAPM model which are based on returns on stock does not invalidate the use of CAPM model in the estimation of cost of capital for projects in the decisions of capital budgeting.

According to Sincere (2004), CAPM model presents a theory that is simple and also delivers simple results. In conclusion, it is true that CAPM is not a perfect theory, buts its spirit is correct. CAPM provides investors with a usable risk measure that assist investors in determining the return they deserve for investing and risking their money.