Finance Research Proposal on Formulating well-defined asset pricing theories

Formulating well-defined asset pricing theories

Introduction

Asset pricing theories concern themselves with explicating the prices for the financial assets in the uncertain business world. The uncertainty, in this case, is explained using probability distributions, and it can be understood as the beliefs that economic agents hold regarding business practices (Roll, & Ross, 1995). These theories are important because they help in predicting the prices for the assets in the uncertain market. However, even though these theories are important in predicting the prices for assets, the current theories are not always accurate in doing so because most of their predictions are usually inaccurate. Some of the factors that affect the accuracy of these theories include their inaccurate assumptions, weaknesses and subjective nature for these theories (Alghalith, 2009). This research proposal proposes a research study that will research and formulate well-defined asset pricing theories that can predict asset prices accurately. The understanding is that the current theories need to be reviewed to make them effective in predicting assets’ prices.  

Purpose

The purpose of this study is to address the current challenges facing the current asset pricing theories and propose new theories that will be accurate in predicting the prices for assets.  

Problem statement

The current theories on asset pricing rely heavily on subjective beliefs as well as inaccurate econometric estimates. In this response, they do not provide feasible solutions for determining the prices of assets in the uncertain business world because they do not deal with all aspects that interfere with those prices. On one hand, the CAPM deals with essential risks while the APT, on the other hand, deals with the inessential risks. This means that each theory deals with a certain set of risks leaving a vacuum of joint between the two theories and because other theories base their arguments on these two theories, the current theories do not predict assets’ prices accurately. As a result, there is the need to evaluate the current theories and propose new theories that will be both subjective and objective in nature (Alghalith, 2009). The new theories will deal with the inaccuracies, weaknesses, and limitations for the current theories. 

Literature review

The current theories on asset pricing presume that the expected returns on assets depend only on the total risk embodied in the assets and that it is not possible to diversify these risks. This is in contrast to the capital asset pricing model that presumes that some risks can be diversified by investing in different portfolios. This notwithstanding, these theories rely heavily on subjective beliefs as well as imprecise econometric approximations (Alghalith, 2009). While this is the case, theoretic aspects for these theories suffer from serious limitations and they lack definite experimental validity. The most common theories in this area of study are the arbitrage pricing theory (APT) and capital asset pricing model (CAPM). Other theories build on the two theories; hence, they are related to these two theories in one way or the other (Merton, 1973).   

The CAPM theory that developed in the 1960s has its basis on the idea that not all market risks influence the assets’ prices and in this respect, this theory argues that different portfolios can diversify risks. This means that a risk that can be diversified by investing in other areas should not affect the price of an asset. This argument introduces the idea of diversification. However, while this might be truthful in some cases, it might not be true in all cases because some risks are difficult to diversify. Besides this, the CAPM offers a powerful method of measuring risk as well as the probable relationship between returns and risks (Roll, & Ross, 1995). However, it is a substitute for the APT given that the two theories claim a linear relationship between assets’ expected returns and risks even though the two theories are disjoint.

Though CAPM theory appears to be the best asset pricing theory, this theory is still subject to both empirical and theoretical criticisms. In terms of theoretical criticisms, this theory is subject to the mean-variance criticisms associated with Markowitz mean-variance criterion (Merton, 1973). This happens because CAPM theory has its basis on the mean-variance criterion developed by Markowitz. On the other hand, the empirical records for this theory are poor that they invalidate its applications (Fama, & French, 2004). For example, using regression approach and time series, Fama and French show that debt equity, book-to-market ratios and earnings-price explain the expected stock returns that market beta provides. They also show that different price ratios provide the same information about the expected asset returns (Fama, & French, 2004). This demonstrates the empirical failures for the CAPM theory in predicting assets’ prices.

As an asset pricing model, CAPM asserts that the risk premium for the assets depends mainly on the diversifiable risks in the market. The assumption is that all investors in the market choose portfolios that are mean-variance efficient (Perold, 2004). In this response, this theory bases its argument on a subjective belief. On the other hand, the APT theory also rests on the same subjective belief because it assumes that investors will only invest in a market that does not have transaction costs and taxes (Bellalah, & Wu, 2009). Based on this understanding, it is clear that most asset pricing theories are subjective in nature. However, these theories should be both subjective and objective for them to be effective in pricing assets.       

Largely, the current theories on asset pricing concentrate on the aspect of identifying and measuring the relevant components of risks that influence the expected returns on assets. They try to understand these aspects from different points (Alves, 2013). For example, on one hand, CAPM deals with the essential risks that threaten the expected returns of assets and refers to this risk as beta. The inessential risk is unimportant in this theory because an identical portfolio with lower level of risk can eliminate this risk (Khan, & Sun, 1997). On the other hand, the APT theory evaluates all systematic risks in the market and tries to relate the assets to exposure to these risks in relation to their expected returns. By so doing, both APT and CAPM theories capture different sets of risks and they also address different aspects when evaluating the probability of taking such risks (Roll, & Ross, 1995). The CAPM theory neglects the effect of unsystematic risks whereas the APT theory neglects the essential risks in its analysis. Based on this fact, the two theories are disjoint.

Irrespective of the shortcomings of the current asset pricing theories, almost every theory makes certain assumptions for it to price the assets. The APT assumes that all securities in the market have finite variances and expected values. It also assumes that some agents in the market can form well-diversified portfolios while other agents cannot form those portfolios (Hays, Upton, & Carroll, 1997). In addition, this theory assumes that there are no taxes in the market and ignores the transaction costs. While it is important to make some assumptions when formulating theories, some of these assumptions are not practical. For example, it is impossible to have a market system that does not have taxes and transaction costs (Cetin, Jarrow, & Protter, 2004). In this respect, the APT theory is theoretically incorrect and needs to develop further. On the other hand, the CAPM theory assumes that investors have identical preferences, they have same information and that they hold the same portfolios. These assumptions are quite difficult to achieve in reality.

Methodology

The proposed research study intends to evaluate the current asset pricing theories, show their weaknesses, limitations and inaccuracies. Once the proposed research study evaluates the limitations and inaccuracies for the current theories, the researcher will be in a position to propose and develop effective theories. The proposed theories will deal with the current limitations and inaccuracies that affect the current asset pricing theories (Perold, 2004).

Based on the proposed strategy, the proposed research study proposes to use the qualitative research method to conduct its research. The proposed qualitative research method will involve evaluating and analyzing the previous studies on asset pricing theories. From this analysis, the study will pinpoint the limitations, weaknesses and inaccuracies for the current asset pricing theories. Based on the findings, the researcher will propose and develop the new accurate theories that will be both subjective and objective. Above all, the proposed theories will be effective in predicting the accurate asset prices thereby help in making the right decision (Hays, Upton, & Carroll, 1997). This research design suits the proposed study because the proposed research study will not deal with data.          

Timeline

It would be important to start by acknowledging the fact that the proposed research study will evaluate the current theories on asset pricing one by one. This will include the development of respective theories, their limitations and anything else that relate to these theories (Cetin, Jarrow, & Protter, 2004). Upon acknowledging this fact, then it would be important to understand that the proposed research study might take considerable time to be completed approximately six months. The researcher proposes to spend the six months in the following manner. The first one month will involve proposing the research study and outlining what each chapter of the study will cover. The proposed one month for proposing the research study will involve contacting the supervisor on anything to be included in the research study together with researching further on the topic. The second month will involve evaluating the in-depths of the proposed research study. This will involve identifying all the current asset pricing theories together with their current developments. The third month will involve outlining the findings for the current asset pricing theories from the previous month. The outlining for the findings will encompass identifying the various aspects proposed to be studied in the research study. The fourth and the fifth month will involve researching and writing the proposed research study and the sixth month will involve finalizing the research paper. This simple outline indicates the timeline for the proposed research study.           

Expected outcomes

The proposed research study expects that the proposed theories will help remedy some of the challenges facing the current asset pricing theories. Accordingly, the proposed asset pricing theories will minimize inaccuracies in the current theories, make few or no assumptions and deal with the current weaknesses in the field of study. In this respect, the proposed research study will be an achievement in asset pricing (Perold, 2004).

References

Alghalith, M. (2009). Alternative theory of asset pricing. Journal of asset management, 10; 73-74.

Alves, P. (2013). The Fama French model or the capital asset pricing model: international evidence. The international journal of business and finance research, 7(2); 79-89.

Bellalah, M., & Wu, Z. (2009). An intertemporal capital asset pricing model under incomplete information. International journal of business, 14(1); 1047-63.

Cetin, U., Jarrow, R., & Protter, P. (2004). Liquidity risk and arbitrage pricing theory. Finance stochast, 8; 311-341.

Fama, E., & French, K. (2004). The capital asset pricing model: theory and evidence. Journal of economic perspective, 18(3); 25-46.

Hays, P., Upton, D., & Carroll, D. (1997). Stability of the arbitrage pricing theory model factors. Quarterly journal of business and economics, 36(2); 71-81. 

Khan, M., & Sun, Y. (1997). The capital-asset-pricing model and arbitrage pricing theory: a unification. Proc. Natl. acad. Sci 94; 4229-4232.

Merton, R. (1973). An international capital asset pricing model. Econometrica, 41(5); 867-888.

Perold, A. (2004). The capital asset pricing model. Journal of economic perspective, 18(3); 3-24.

Roll, R., & Ross. S. (1995). The arbitrage pricing theory approach to strategic portfolio planning. Financial analysts journal, 51(1); 122-131.