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CAPM - International Consolidated Airlines, FTSE-100

Introduction:

This report will help us understand the stock beta, its analyses & calculations, implementations. We will learn that how the stock beta can be used for calculating the Security Characteristics Line.  This report discusses the some practicalities and the implementation of Stock Beta and Capital Asset Pricing Model (CAPM). We will try to understand the number of different ways in which the stock Beta and the CAPM can be used. We have taken a stock of an airline company International Consolidated Airlines whose stock name is ICAGL and calculated its beta and have compared it with the Beta of a market index FTSE-100 by calculating it. We have also compared this beta with a published beta of the same stock and beta of the industry of the company. We research and understand the possible reason of difference between the different Betas mentioned above. Then there is Security Characteristics Line which is drawn by applying the regression line on the calculations of Stock and FTSE-100 index.

 

After that there is the turn of CAPM. We have explained there that how the CAPM limitations came be overcome by using some techniques.  After that we have discussed that how the CAPM is helpful in the risk management and how practicable the CAPM model is.  

 

 

Q.1 International Consolidated Airlines Monthly Stock Prices 2 Year to date

 

Date

Open

High

Low

close

Avg. Volume

Adj. Close*

01-May-12

175.9

181.2

174.4

176.5

6,328,900

176.5

02-Apr-12

180

184.6

161.9

176.4

9,033,300

176.4

01-Mar-12

165

184.8

159.7

178.9

10,065,900

178.9

01-Feb-12

177.3

219.34

157.4

164.2

8,709,100

164.2

03-Jan-12

150.2

181.14

143.6

177.2

9,500,800

177.2

01-Dec-11

148.8

159.24

140.7

147.4

5,099,300

147.4

01-Nov-11

164.1

168.85

130.97

147.5

11,436,200

147.5

03-Oct-11

149.9

182.47

144.7

171.9

8,179,900

171.9

01-Sep-11

174.6

177.6

137.7

153.1

10,296,500

153.1

01-Aug-11

239.4

240.4

162.2

174.8

11,363,200

174.8

01-Jul-11

253.2

260

222.3

237.3

8,078,500

237.3

01-Jun-11

237

255.1

221.6

253.7

8,269,500

253.7

03-May-11

240

255

227.6

236.5

8,855,600

236.5

01-Apr-11

228

240.4

214.3

238.2

8,151,400

238.2

01-Mar-11

228

271.2

211.2

227

13,726,300

227

01-Feb-11

256.2

271.2

222.9

224.5

334,143,400

224.5

04-Jan-11

275

307.3

249.5

255.87

18,403,200

255.87

01-Dec-10

261

280.9

258.5

272.5

6,101,900

272.5

01-Nov-10

270.4

287.9

255.1

255.6

8,576,300

255.6

01-Oct-10

242.6

290

238.1

270.7

10,142,600

270.7

01-Sep-10

212.8

247.6

208.5

242.8

7,108,200

242.8

02-Aug-10

222.9

238.2

207.2

209.9

7,066,000

209.9

01-Jul-10

194.7

228

185.5

219.6

8,456,300

219.6

01-Jun-10

201.5

219.9

187.2

196

6,518,500

196

 

 

FTSE Monthly Prices 2 Year to date

Date

Open

High

Low

close

Avg. Vol.

Adj. Close*

01-May-12

5,737.80

5,819.90

5,639.80

5,655.10

1,113,396,700

5,655.10

02-Apr-12

5,768.50

5,890.20

5,576.40

5,737.80

963,545,000

5,737.80

01-Mar-12

5,871.50

5,989.10

5,726.50

5,768.50

1,009,943,900

5,768.50

01-Feb-12

5,681.60

5,964.00

5,680.70

5,871.50

966,777,500

5,871.50

03-Jan-12

5,572.30

5,806.20

5,572.30

5,681.60

989,530,200

5,681.60

01-Dec-11

5,505.40

5,631.90

5,328.70

5,572.30

753,211,800

5,572.30

01-Nov-11

5,544.20

5,616.00

5,075.20

5,505.40

1,037,997,400

5,505.40

03-Oct-11

5,128.50

5,747.30

4,868.60

5,544.20

907,649,300

5,544.20

01-Sep-11

5,394.50

5,449.70

4,928.10

5,128.50

981,980,500

5,128.50

01-Aug-11

5,815.20

5,913.50

4,791.00

5,394.50

1,232,405,500

5,394.50

01-Jul-11

5,945.70

6,084.10

5,752.80

5,815.20

858,918,500

5,815.20

01-Jun-11

5,990.00

5,995.20

5,644.40

5,945.70

921,906,300

5,945.70

03-May-11

6,069.90

6,103.70

5,810.50

5,990.00

942,955,800

5,990.00

01-Apr-11

5,908.80

6,091.80

5,858.30

6,069.90

760,782,900

6,069.90

01-Mar-11

5,994.00

6,052.10

5,591.60

5,908.80

904,076,700

5,908.80

01-Feb-11

5,862.90

6,105.80

5,861.00

5,994.00

897,500,900

5,994.00

04-Jan-11

5,899.90

6,090.50

5,815.40

5,862.90

939,491,400

5,862.90

01-Dec-10

5,528.30

6,021.50

5,528.30

5,899.90

667,441,600

5,899.90

01-Nov-10

5,675.20

5,902.10

5,519.20

5,528.30

940,455,100

5,528.30

01-Oct-10

5,548.60

5,794.30

5,547.50

5,675.20

846,543,400

5,675.20

01-Sep-10

5,225.20

5,650.30

5,225.20

5,548.60

860,118,500

5,548.60

02-Aug-10

5,258.00

5,418.60

5,070.90

5,225.20

922,769,100

5,225.20

01-Jul-10

4,916.90

5,411.50

4,790.00

5,258.00

989,418,400

5,258.00

01-Jun-10

5,188.40

5,331.50

4,898.50

4,916.90

1,167,363,700

4,916.90

 

 

 

Returns

FTSE-100

AIG

-5.23%

-2.58%

6.94%

12.04%

-0.62%

-4.42%

6.19%

15.67%

2.28%

11.49%

-2.59%

-5.58%

6.72%

6.61%

-0.63%

-6.10%

2.24%

-12.26%

-1.42%

1.11%

2.73%

4.93%

-1.32%

-0.71%

-0.74%

7.27%

-2.19%

-6.46%

-7.23%

-26.34%

-4.93%

-12.41%

8.11%

12.28%

-0.70%

-14.19%

1.22%

-0.07%

1.96%

20.22%

3.34%

-7.34%

-1.75%

8.95%

-0.53%

-1.40%

 
Name
 
Published Beta
 
Name
 

 

Anticipated Beta

1.831862

Published Beta

1.30

Beta difference

0.531862

 

 

There can be number of reasons for the anticipated beta to be high. The first can be this that we have calculated the beta from the monthly values of the stock prices of the company whereas the published betas are mostly calculated from the daily stock prices of a company. Following are the major reasons of the difference between the two Betas of the same stock:

Index Used:

In our calculation of beta we have used the FTSE-100 Index historical prices whereas the published beta may have used the any of Standard and Poor’s Index or any other one (Lee & Hood, 2011)

.

Time Frame:

We have calculated the beta using the historical prices of 2 years whereas the publisher may have used some other period of time (Lee & Hood, 2011).  

Calculation Method:

Bloomberg and Fact Set generally perform a regression on the weekly prices for the stock and the index whereas we have calculated beta using the monthly historical prices.

Publishers also perform a regression but they do not give us detailed results about the data and the calculations. So we can’t say that what period, Index, time differences of prices they have used. To find the fundamental beta for a company’s stock, we can get from the Northfield Portfolio Optimizer accessed via Fact Set (Lee & Hood, 2011).

 

 

 

 

 

 

 

Q.2 Beta Opinion:

I was not anticipating same beta for the stock because the average industrial beta for the Air transport industry is 1.21 Data used is as of January 2012. I was anticipating a close Beta to the Air transport industry.  By our calculations Beta is 1.832. There is much difference between the two betas worth 0.621861735 which is a lot which is a lot. So comparing to the industry the beta is quite high. It means that the company is having more market risk than the most of the other companies in the air transport sectors. As most stocks have the higher beta than 1 but this calculation of beta is much greater than 1 which indicates that the security's price will be more volatile than the market. 1.832 of beta means the stock price is 83.2% be more volatile than the market (Koller & Goedhart, 2002)

.


 

Q.3 Overcoming CAPM Limitations

 

When the Company carry out several different projects which have different levels of risk, the evaluation becomes a bit difficult. In these types of circumstances one approach can be to take a composite cost of capital of the company and accept only those proposals whose returns surpass this limit but, this clearly will mean that we prefer the riskier projects over lesser risky project.

 

 

Formula of Robert Hamada for adjusting the Leverage factor

 

The Beta that we assign to any project is probable to experience the changes along with the changes in a firm’s capital structure. If a particular company’s capital structure is fully equity based then its Beta is expected to be lower than a similar company includes debt in its capital structure or goes for borrowing. There are number of factors including risk of default, risk of bankruptcy and costs of agency which contribute to this fact (Parasuraman, 2002).

 

Robert Hamada has made a formula based on the proposed concepts of Montigliani and Miller for determining a Levered Beta given the unlevered beta and also asserting an unlevered Beta given the levered Beta. So, if Beta of a company is accessible and that Beta also has been determined on the idea that the company is unlevered (debt free), we now can easily determine the Beta of the company if it carries out some borrowing when we use the formula given below:

Name

 

The Pure Play technique

Believing the concept that we must have the divisional Betas to find out the separate costs of capital, the next step is to set up the means of finding out the Beta with a higher degree of accuracy. One method for this purpose is Pure Play technique. In first step, we identify the firm which reasonably similar to the project for whose Beta is under estimation. The ratio of debt to equity or the leverage position should also be considered. After properly adjusting the tax factor and by applying the formula of Robert Hamada for adjusting the Leverage factor, we can ascertain the proxy Beta of the project by supposing that it is an unlevered one (Parasuraman, 2002).

 

 


 

Q.4 CAMP as Risk management Model and practicability

FORMULA FOR CAPM

There is a linear relationship between the required return on any investment project and systematic risk of that project which is represented by the CAPM model’s formula, given as under:

Formulae Sheet:

Eri = Rf + βi x (Erm - Rf)

Eri = return required on financial asset i

Rf = risk-free rate of return

βi = beta value for financial asset i

Erm = average return on the capital market

CAPM is one of the most important and highly famous models of financial management. It is criticized a lot as being an unrealistic model due to its assumptions as follows:

The first assumption is that investors hold the portfolios which are diversified means that investors will only require a profit for the systematic risk on their portfolios consequently unsystematic risk is ignored by the model. According to another assumption CAPM uses single-period transaction horizon in this we cannot compare a return over six months with a return over 12 months. The third assumption describes that investors can borrow and lend money at the risk-free rate of return. According to next assumption investors trade in a perfect capital market means that all the securities are perfectly valued. A perfect capital market also requires that there are no taxes, no transaction costs; free and easy availability information to the all investors, all the investors are risk averse, they are rational and all of them desire to maximize their own utility and also in the market there are a vast number of buyers and sellers. But it reasonable to say that the assumptions of the CAPM are idealized instead of real-world view, it is a strong possibility that in reality there is an existence of linear relationship between required return and systematic risk (Accountant 2008).

DISADVANTAGES OF THE CAPM

There are a number of disadvantages and limitations as follows:

To use the CAPM, we need to assign values to the variables of risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta (Accountant 2008).

Considering the Risk free rate interest on short-term Government debt is often considered to be the risk-free rate of return which is not fixed but it changes in accordance with the economic circumstances on daily basis (Accountant 2008).

It is not easy to find a value for the Equity Risk Premium. In the short-run period, a security market can give a negative return rather than a positive one. It is therefore a routine practice to use an average value of ERP over the long-term, but it is also found that the ERP is not stable over time.

Beta values of almost all the stock market companies are now calculated and published on a regular basis. But the problem is that uncertainty comes up in the value of an expected return for the reason that the value of Beta is never constant, it changes over the period of time. Difficulties can arise while using the CAPM for calculating a project-specific discount rate. For example, a general problem is finding a suitable proxy beta, as proxy companies hardly ever undertake only a single business activity. So the proxy beta for an investment project must be separated from the equity beta of the company. One limitation of using the CAPM in evaluating an investment project is that the assumption of a single-period time horizon has the probability with the multi-period investment nature of project evacuation. Variables of CAPM are assumed to be constant in successive future periods whereas, the time has proved that in reality it is not true (Accountant 2008).

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