Practical application of CAPM model to emerging economies in the light of 2008 global stock market meltdown
Practical application of CAPM model to emerging economies in the light of 2008 global stock market meltdown
By SUNIL K KEWALRAMANI
November 20, 2008
The phrase “expected returns” is used in the financial world as a reference to the rate of return that an investor should require from a certain investment, given its risk profile. The relative return philosophy is based largely on three theories : Harry Markowitz’s Modern Portfolio Theory (MPT), Eugene Fama’s Efficient Market Hypothesis (EMH), and William Sharpe’s Capital Asset pricing Model (CAPM). EMH provides that securities prices reflect all known information and inhibit investors from finding mispriced securities. CAPM provides a framework for constructing portfolios with an optimal risk-reward relationship.
The financial investment research of Markowitz and its application of mean-variance analysis showed mathematically how the risk of individual bonds and stocks make their contributions to risks and the return on a financial portfolio. Such analysis is in practice meant to be the starting point for financial diversification considerations and decisions. Moreover, the modeling of Markowitz was the fundamental tool for William Sharpe (1964) when he introduced what Grinblatt and Titman call "the most commonly used tool for project and securities valuation, the Capital Asset Pricing Model (CAPM)." The Royal Swedish Academy of Sciences (1990) described CAPM as "the backbone of modern price theory for financial markets." In CAPM, Mr Sharpe found the most efficient portfolio was the market. He also related the risk of an individual security to the entire market, which was termed “beta”. According to Mr Sharpe, most of a stock’s risk stemmed from the market. The idea of an index fund—one passively tracking the entire market—came directly out of CAPM.
"APPLYING CAPM"
The extensive use of the Capital Asset Pricing Model (CAPM), assists in isolating the target sector where potential opportunities appear. For example: companies with small capitalization often have increased price fluctuation, while having both the highest expected return and risk. In between these two extremes lie corporate stocks and bonds. Attempt is made to employ a method that determines when individual stocks deviate from this important relationship. When stocks show high potential return but lower than expected risk, they are deemed as "undervalued" or "discounted". The philosophy is based on value investing which aims to find good companies, run by high quality management with low market prices, relative to current values. Investment managers select sound companies that are selling at a low Price/Earnings Multiple with little or no debt.
For example, if an investor can make 8% p.a. by investing in riskless RBI bonds, then he/she will not settle for less than this as an expected return for investing in a riskier asset. Beta is the component which varies from one stock to another. For example,financial stocks are extremely sensitive to interest rates, and with every movement in either US Fed Reserve/Reserve Bank of India/Bank of England/Bank of Japan monetary policy, they would experience huge fluctuations. Investments such as financial sector stocks which add more risk to the market portfolio will have higher betas than those which add less risk.
Assusing a risk-free return of 8%, beta of 1.78 for IFCI and a risk premium of 7%, we find the expected return for IFCI stock as
The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of RISK, known as RESIDUAL RISK or alpha, by holding a diversified portfolio of assets (see MODERN PORTFOLIO THEORY). These alpha risks are specific to an individual asset, for example, the risk that a company’s managers will turn out to be no good. Some risks, such as that of a global RECESSION, cannot be eliminated through diversification. So even a basket of all of the SHARES in a stockmarket will still be risky. People must be rewarded for investing in such a risky basket by earning returns on AVERAGE above those that they can get on safer assets, such as TREASURY BILLS. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset’s PRICE is affected by the risk of the market as a whole. The market’s risk contribution is captured by a measure of relative volatility, BETA, which ¬indicates how much an asset’s price is expected to change when the overall market changes.
Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk-free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset’s beta.
At some point in time, the Infosys ADR when converted into Indian Rupees would fetch more than the stock would in Indian Rupees. This mean that, for the same level of risk, price of Infosys would vary from one stock exchange to another, leading to arbitrage opportunities. A fundamental idea of much traditional investment thinking is that markets are efficient. Leading practitioners of absolute return investing, however, make their livings by finding and capitalizing on market inefficiencies. While recognizing a tendency towards efficiency, they think of market efficiency as a process rather than as a consistently existing condition. Recent reports and studies are acknowledging the role that hedge funds and other absolute return investments play in increasing or improving market efficiency.
In recent years, due to the opening of emerging markets, there are more and more choices in the investment. The high investment return in the international arena especially the emerging markets has attracted a lot of investors. This is because :
Benefits from international investing,
��Diversification is an established investment strategy that can play a critical role in helping to balance risk and the potential of the long-term return.
��International Investing offers maximum performance.
��It provides opportunities in markets that have a greater growth potential.
��Benefits from international currency movements.
��A way to add a global dimension to an overall investment portfolio.
However, how to select a profitable investment target is very important in so many emerging markets, for example, Asia, Latin America, Europe and Africa. After the liberalization of emerging markets, the flow of capital also becomes easier and the relative investment risk increases. The markets integration condition and risk price before and after the liberalization of the market are subjects of contemporary interest. In this study, International capital asset pricing model (ICAPM) of Tai (2007) and International CAPM model added with exchange rate risk factor are used. Hardouvelis et al. (2006) use two stages Multivariate GARCH-in-Mean model to estimate the markets integration and cost of capital for each America and Asia emerging market. It can be seen from the result that before the liberation of the market, A Latin America market, Chili market are completely integrated with the world market but Argentina, Brazil, and Mexico and Asia markets have no evidence of full integration. Besides, in the cost of capital, all the countries show reduced the capital cost after market liberalization.
Some core assumptions of the capital asset pricing mode (CAPM) are :
• Investors are rational and prefer more wealth to less.
• Investors share homogeneous expectations about the distribution of future security returns.
• Investors can borrow and lend at the risk-free rate.
• Investors seek to maxmimize a linear function of the mean and variance of security returns.
• Taxes and transaction costs are zero. None of the securities suffers from illiquidity.
Asset markets in emerging economies are generally thought to be less efficient than the larger, more liquid and thick markets in some rich economies. This suggests the possibility of profiting by detecting inefficiencies in emerging asset markets. A number of authors suggest that one way of looking for opportunities is to test asset prices for cointegration. In ‘Cointegration and Market Efficiency’, Richard J Sweeney in elaborate detail points out that cointegration among asset prices, or its lack, has no implications by itself for efficiency. If risk premia are time-varying, then it is possible that cointegration and the efficient markets hypothesis (EMH) jointly hold. There are strong restrictions, however, on how risk premia must vary to ensure that cointegration and the EMH actually hold. These restrictions mean that the finding of cointegration allows sharper, more structured tests of the EMH. First, the parts of assets’ rate of return that are predictable from cointegration must equal risk premia. Since the predictable parts of cointegrated assets’ rates of return, vary over time, risk premia must vary pari passu. Priced risk factors beyond the market are generally required. Thus the Capital Asset pricing Model is highly unlikely to be consistent with cointegration and efficiency. The betas, not the risk premia, of at least some priced non-market risk factors must depend on the cointegrating error. Second, the part or parts of assets’ rates of return that are not predictable from cointegration must be explicable cross-sectionally in terms of risk-factor realizations and idiosyncratic error terms. Further, the forecast errors’ dependence on realizations of non-market risk factors must vary over time with the cointegrating error.
While a useful tool and model for developed markets (please refer “Beta is Dead” 1993 by Fama and French, for an analysis of the CAPM’s shortcomings, the CAPM model does not work for emerging markets because :
a) A standard assumption made in financial theory is the normal distribution of asset returns. This is not valid for emerging markets, and the CAPM theory does not fit the actual data
b) The very fact that emerging markets are emerging shows that they are imperfect in their integration. They overreact to movements of stock prices in the developed world, as was revealed in the global stock market meltdown in January 2008. The bet on decoupling has been particularly evident since the US Fed started cutting interest rates in August 2007. That led to the belief that the US would slow but that the extra liquidity would help emerging markets grow much faster. Share prices in “BRIC” markets—Brazil, Russia, India and China rose more than 50% in a matter of weeks, while the S&P 500 of the US rose only 11%. On the downside, since the MSCI WORLD INDEX peaked on Oct 31, 2007; the MSCI BRIC INDEX has fallen some 22 % and the FTSE-EUROFIRST 300 21 %. Both have performed worse than the S&P 500 of US itself, down by less than 14%.
c) CAPM is limited to Mean-Variance analysis; beta is based upon standard deviations (volatility). Skewness and kertosis (“fat tails”) are more apparent in historical emerging markets’ return data, suggesting greater downside risk and event risk for emerging markets. A Mean-Variance analysis misses this. Furthermore, correlations between average returns and the world beta indicates a zero or negative slope for emerging market countries, suggesting that countries with higher risk require lower rates of return which is untrue.
d) Suppose you are an investor in Indian equities. You believe that markets are reasonably efficient, that you have no special information, and that active managers will have a difficult time outperforming the market portfolio over time. Thus, you wish to hold the Indian market. But what is the Indian market ? Is it the SENSEX, or is it S&P CNX NIFTY or is it the CNX NIFTY JUNIOR or is it the CNX 100 or is it the BSE-500 ? Each of these potential benchmarks has different structural characteristics and implications for the investors’ ultimate portfolio. Besides, the benchmark serves not only as a proxy for the asset class, but also as a performance target for active managers. An investor can generally obtain the systematic return of an asset class through indexing—passive management. The decision to invest in an asset class—say emerging markets—is distinct from the decision to hire an active manager.
e) At the heart of the issue of benchmark construction is the tension between the tenets of the Capital Asset Pricing Model (own the world, all the known risks are adequately priced in), and real world definition, implementation and market structure issues. The possibility of misspecification of emerging market benchmarks is demonstrated by the fact that several large pension plans exclude on investability grounds some of the countries included in major benchmarks. With $13 trillion of pension assets worldwide (out of an investable global stock market capitalization of roughly $25 trillion), and given the growth of cross border investing, the issue of benchmark definition is not trivial.
Korea and Taiwan, for example, may graduate from emerging to developed status in the next two years. At that point, a whole new class of investors--indexed and active alike--will invest in these countries. Such a move will be carefully considered. But, even if commercial and behavioral influences will be negligible in the decision to graduate countries, the benchmark providers need to codify more systematically the combination of business, regulatory and political practices that define a developed market, and apply these to prospective graduating countries.
f) Heavy unwinding of leveraged positions has been witnessed in India, for example, in January 2008, where new retail participants were treated to fantastic leveraged treats of investing in expensive stocks contributing just 10 % or so. The total leveraged position (in excess of Rs 1 lakh crore or Rs 1 Trillion) contributed heavily to the stock market crash. Majority of stock brokers have unwound their leveraged positions in the futures and options arena. Such was the intensity that the open interest in F&O fell by 17% on Monday, Jan 21 and by further 15% on Tuesday, Jan 22 2008. The severity of margin calls was such that the futures prices resulting from a forced liquidation of positions started getting reflected in the cash market, and even those who wished to buy at beaten-down prices were unable to do as brokers demanded cheques to be cleared beforehand. This definitely inhibited the smooth functioning of capital markets, and price discovery was more of the prices in a state of distress. Only some institutional investors were able to get their orders executed, and others who were willing to buy and take risk, were unable to do so due to artificial barriers constructed.
Drawing a parallel to the May 2006 crash; the day when Reliance Petroleum shares were listed on the Bombay Stock Exchange, the total Open Interest in Futures was at Rs 33,000 crores (Rs 330 Billion). However, by June 14 2006, when the markets bottomed out in India, the open Interest fell to Rs 10,000 crores (Rs 100 Billion), indicating that 70 % of the Open Interest was unwound.
g) CAPM model is ill-suited for considering extraordinary events such as bubbles, depressions, hyperinflation, sudden and panic falls like the one witnessed in the global stock market meltdown and terrorist attacks, most or all of which have been commonplace in today’s times.
h) Of utmost importance while evaluating the CAPM model to emerging economies is the assumption of CAPM ignoring taxes, transaction costs and illiquidity. Sometimes, these have such grave significance that the decision to invest or not can be based entirely on these factors alone. Besides, taxes dramatically vary from one emerging economy to another; not only that, the Double Tax Avoidance Agreements that one country has with another greatly impacts the mean-variance analysis.
Steps for valuing firm in an emerging economy on a real and nominal basis :
• Calculate the revenue, EBITDA, Invested Capital and EBITA on a real basis.
[Note: Invested Capital= Net PPE (End)+ NWC;
Net PPE (End)= Net PPE (Beg)- Depreciation +Capital Expenditure.
Depreciation is calculated by Dividing the Beg. PPE by the number of years.]
• Calculate the Revenue, EBITDA, Depreciation and EBITA on a nominal basis.
• Calculate the real NOPLAT
• Calculate FCF on a real and nominal basis.
• Estimate firm value in both real and nominal terms by discounting the real and nominal FCF at the real WACC and the nominal WACC. The nominal WACC is not the same every year because of the inflation rate. (1+nominal rate)= (1+real rate)(1+ inflation rate)
Effect on Financial Ratios: Generally the ratios in real terms are accurate and the ratios in nominal terms are incorrectly estimated. ROIC (Return on Investment Capital= NOPLAT/Beg. Invested Capital) is overstated in nominal terms. NWC/Revenue is correctly states in both real and nominal terms. Ratio of PPE/Revenue is generally understated in nominal terms.
Two ways of incorporating emerging market risk in the valuation process-
a. Adjusting the cash flows in a scenario basis b. Adjusting the discount rate by adding a country risk premium. Adjusting the cash flows has more support because of the following reasons-
• Country risks are diversiable
• Companies respond differently to country risk. (All companies might not use the same country risk premium. So it’s better to adjust the individual cash flows).
• There is no systematic method to calculate a country risk premium.
• When managers have to discuss emerging market risks and their effects on cash flow in scenarios, they gain more insights than they would get from country risk premium.
Some assumptions that are used while calculating WACC-
We have adopted the perspective of an international investor who has a diversified portfolio. As long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Another assumption is that most country risks are diversifiable from the perspective of a global investor. We therefore need no addl. risk premium in the cost of capital when discounting cash flows.
Since there is no dollar-denominated bond existing in India,some financial pundits have suggested using as a proxy, the dollare-denominated bond of another country with similar country risk, such as any of the other BRIC ountries, like Brazil, Russia or China. However, when using the Country Risk Premium approach,one should not simply use the sovereign risk premium which is the difference between. the long term US bond yield and a dollar denominated local bond’s yield with the same maturity. This is because this difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued moves closely in line with the payments on government bonds.
We need to understand estimates from different analyst sources because the underlying assumptions will vary. For eg- A high country risk premium might be used along with a very high growth rate and a low country risk premium might be used with a low growth rate. So the final value might still be the same.
In his book “Financial Decisions in Emerging Markets” Jaime Sabal elucidates what a Country Risk is and what is not supposed to signify :
Country Risk Is Not the Same for All Projects. The same country risk premium should not apply to every investment in a particular country. Some countries have a better reputation in some business sectors than in others. Hence, the country premium for the more reputable sectors should be lower. This could be the case of investment in the banking sector in Panama, or in bananas in Ecuador. Relatively more stable and consistent government policies should be expected in these sectors given that they are critical sectors of these countries’ economies. Likewise, there could be some activities with higher country risk. A possible example is agriculture, which many nations consider to be a matter of national security. In consequences, governments usually interface through subsidies, price controls, import quotas, and other measures.
Last, it is feasible, through contracting arrangements, to reduce country risk for certain types of investment, - for example, a joint venture with the local government in a state-controlled sector (e.g. mining). It is reasonable to expect that this would result in less unfavorable interference since such actions would hurt not only the investors but also the government as a partner.
Credit Risk Is Not Equivalent To Country Risk Government bond prices (in hard currency) of developing countries depend on investor’s expectations of compliance with the promised payment schedule. Adding the country risk premium to the discount rate assumes that the risk of noncompliance by the government is the right proxy for country risk. This is not accurate in most cases.
The Modified CAPM model :
It recognizes that a projects’ results can be significantly related to two or more markets. For instance, the income (the risk) of an Indian Company exporting to the United States and Brazil must be affected by what happens in these countries. This is why we use a weighted beta for the project.
For the sake of simplicity, we will use the U.S. dollar as the relevant currency. In other words, we are thinking of investors with consumption baskets that are dependent on the U.S. dollar. Likewise, we adopt the U.S. stock market as our proxy for the “market portfolio.”
Imaging a textile concern with three relevant markets, one of them the U.S. market. The weighted beta is computed in the following manner:
1. The beta of textile companies in the U.S. market βt,m is estimated. This can be obtained from financial information service.
2. Estimate the betas of each local market with respect to the U.S. market. If we name these markets m and n, their corresponding betas will be βm,M and βn,M. These betas can be estimated by regressing the historical returns of ( representative) local stock indexes against the U.S. stock market returns.
3. Compute the project beta in each market with respect to the U.S. market, βtm,M and βtn,M as follows:
βtm,M = βt,Mβm,M
βtn,M = βt,Mβn,M
where βt,M is the beta corresponding to the textile business in the U.S. market.
4. Find the weighted beta βp with the following formulas:
βp = αMβt,M + αmβtm,M + αnβtn,M
αM + αm+ αn = 1
where the alpha values represent proportional income originating in each market.
5. The modified CAPM is :
E(Rp) = Rf + βp[E(Rm) – Rf]
Where
(a) Rf is the yield of U.S. government bond in U.S. dollars with maturity (or duration) approximately equal to the projects’ horizon.
(b) E(Rm)is the expected return of the proxy for the market portfolio, for instance, the S&P 500 Index of the United States.
A Practical Example Assume a firm with the characteristics shown above. The beta corresponding to the RXT income will be
βtm,M = βt,M βmM = 0.8* 0.69= 0.57
The beta corresponding to the U.S. income, Βt,m = 0.82, is used to find the weighted beta, as follows:
The International CAPM and a Wavelet-Based Decomposition of Value at Risk
Viviana Fernandez and group formulated a time-scale decomposition of an international version of the CAPM that accounts for both market and exchange-rate risk. In addition, theyderived an analytical formula for time-scale value at risk and marginal value at risk (VaR) of a portfolio. They applied methodology to stock indices of seven emerging economies belonging to Latin America and Asia, for the sample period 1990-2004. Their main conclusions are the following. First, the estimation results hinge upon the choice of the world market portfolio. In particular, the stock markets of the sampled countries appear to be more integrated with other emerging countries than with developed ones. Second, value at risk depends on the investor’s time horizon. In the short run, potential losses are greater than in the long run. Third, additional exposure to some specific stock indices will increase value at risk to a greater extent, depending on the investment horizon. Their results go in line with recent research in asset pricing that stresses the importance of heterogeneous investors.
International CAPM, which holds that the world market portfolio is the mean-variant efficient portfolio has its critics,yet has profound insights about the importance of diversification. The correlation of MSCI Emerging Index with the MSCI World Index over the past 5 years is .83, but .68 over 15 years. This proves correlations are increasing. By adding emerging markets to their portfolios, investors can create more efficient portfolios.
Many of the insights developed by the proponents of the new finance theories such as Behavioral finance, Complexity theory and The Adaptive Markets Hypothesis can be applied to better understanding emerging markets. Because emerging markets are those which do not meet all the criteria of classical finance. In addition, they are very volatile, illiquid at times, and subject by definition to periodic shocks that beset the world economy. The new finance helps in understanding of how markets function, particularly in times of financial euphoria or stress, such as the one we are seeing in January 2008.
Behavioural Finance : C.P. Chamley, in his book “Rational Herds : Economic Models of Social Learning (2004) gives good description of herding—people suspending their private judgments and acting on public information. As Andrew Lo (2004) has noted, in economics, theories lead to empirical testing, but in psychology, empirical observation leads to theorizing. At the time of the Reliance Power IPO in India in January 2008, it was widely perceived that the markets will remain buoyant till the IPO is over and listed. They relied on public information rather than their own judgment and took positions in the market accordingly, only to their own peril. This crossover between the fields of finance and psychology provides insights into the effects of emotion and irrational behavior on the financial markets.
Complexity Theory : As outlined by Bernoit Mandelbrot (2004) and others, Complexity theory seeks to deepen our understanding of how markets function by examining :
EXTREME EVENTS : The crash of 1987 or the Global Stock Meltdown of January 2008 are good examples
TRANSITIONS : The reason why trivial happenings on the world stage have a major impact on stock markets ?
CONTAGION EFFECT : Why does the financial contagion work ? Why should a bank going under in UK impact Asian stock markets ?
MULTIPLE EQUILIBRIA : Markets, through speculative attacks, can force a “new equilibrium”.
The Adaptive Markets Hypothesis :
As laid down by Andrew Lo (2004), this theory hypothesizes that agents form beliefs on trial and error basis. In this view, the risk/return relationship in the market is unstable. Market efficiency is context-dependent, arbitrage opportunities may arise from time to time. For example, in January 2008, investors were willing to buy shares when the stock markets got hammered, but brokers were unwilling to sell them until their cheques were encashed. This caused temporary arbitrage opportunities for the investors whose cash balances were lying with the stock brokers. Others were willing to take certain risk, but no return was coming to them, because the risk/return relationship was broken down. This led to arbitrage opportunities for only a few.
When free flow of capital markets is hindered, such as what happened in theaftermath of the January 2008 stock market meltdown, where brokers refused to buy securities for clients until their cheques were deposited and encashed, the functioning of the CAPM (Capital Asset Pricing Model) is also threatened,and in times like these, the above modern theories of finance come to our assistance.
References :
1) ‘Cointegration and Market Efficiency’ by Richard J Sweeney
2) ‘The International CAPM and a Wavelet-Based Decomposition of Value at Risk’ by Viviana Fernandex
3) ‘Rational Herds : Economic Models of Social Learning (2004)’ by C.P. Chamley
4) ‘How the World Works’: Behavioral Finance and Investing in Emerging Markets by George Hoguet
5) ‘Financial Decisions in Emerging Markets’ by Jaime Sabal
EXECUTIVE SUMMARY :
The purpose of this article is to examine the utility of the CAPM model, which is one of the most important risk-return theories, to an emerging economy such as India. This assumes greater importance since with the growth of China and India as twin engines of growth of the world economy, both FDI (Foreign Direct Investment) and Portfolio Investment have been greatly directed toward India and other emerging economies. However, in an emerging economy environment such as India, there are various limitations such as illiquidity, transaction costs, and taxes, which alongwith other factors such as non-availability of free and full information to the investing world in general, act to dilute the importance and free applicability of the CAPM model to conditions prevalent in emerging economies, thus necessitating making variations to the CAPM model.
EXECUTIVE SUMMARY :
The purpose of this article is to examine the utility of the CAPM model, which is one of the most important risk-return theories, to an emerging economy such as India. This assumes greater importance since with the growth of China and India as twin engines of growth of the world economy, both FDI (Foreign Direct Investment) and Portfolio Investment have been greatly directed toward India and other emerging economies. However, in an emerging economy environment such as India, there are various limitations such as illiquidity, transaction costs, and taxes, which alongwith other factors such as non-availability of free and full information to the investing world in general, act to dilute the importance and free applicability of the CAPM model to conditions prevalent in emerging economies, thus necessitating making variations to the CAPM model.
