The Capital Asset Pricing Model (capm)

Introduction

The Capital Asset Pricing Model (CAPM) has broadly used by investors and corporate finance, the reason behind this is because due to the elegance of the model for investor easy to use and obtained expect return while exposing to the systematic risk. The most critical factor within CAPM model is the systematic risk of the single stock; typical systematic risk includes interest rate, inflation, economic cycle, policy uncertainty and widespread natural disasters.

Nowadays, most of the Chinese company choose U.S to go public trade. China has picked up market economic from planned economic since 1978. Almost 40 years later, China has now become a secondary largest economic system in the world. The relatively fast economic growth creates more opportunities and attracts more investors. IPO in U.S. stock exchange has number benefit to Chinese based company.

1.Lower finance cost and shorter time compare IPO in China A & B market. In U.S., approximate 12% of the capital fund invested into Non-U.S. Company.

2.Enhanced its reputation and value by increase media attention.

3.Import foreign technology and management system to improve the domestic company.

4.U.S. stock exchanges provide more liquidity, acceptance and branding to the investor. The US has the largest overall pool of equity capital compare to the everywhere else in the world with a wider margin. Liquidity is critical for an investor as is indicate the sufficiency of supply and demand in the trade market.

China is the largest emerging market in the world; there is some inherent risk associated with the Chinese based company that the U.S. investor could pay attention, such as the government policy, stable relationship between China and U.S. and so forth. Some of these risks would affect the stock performance of Chinese company, while other risks may create ongoing concern of the company, which would also create disaster toward the investor who holds a position of the stock.

This research is aim to address following two question regarding the risk factor in the CAPM.

1.How would systematic risk of policy uncertainty impact to U.S. investor who holds a position of Chinese based company stock?

2.How does trade war affect investors?

The purpose of this research is to introduce and identify the systematic risk of policy uncertainty, which would influence the result of the CAPM model. This research will focus on impaction of following issues.

1.Policy uncertainty risk, what is the possibility of a trade war between China and U.S.

2.What is the impaction of trade war toward the stock performance of Chinese based company that listed on U.S. stock exchanges?

Literature Review

There is a trade-off between risk and return, as the development of portfolio investment management proceed, the non-systematic risk of an asset can be diverse. Therefore only systematic risk remain to be compensated as a return for investors to absorb the risk (Vijay.S 2016). This literature review will first review the fundamental relationship between systematic risk and return in the CAPM, then a different opinion of a trade war between U.S. and China will evaluate to exam the possibility of the trade war.

Systematic risk is the risk inherent in the business environment, which consisted by market risk, credit risk, and liquidity risk (Don M, C. 2016). Because non-systematic risk, also known as non-financial risks that relate to organisation inherent risks, such as operation risk or solvency risk can be transferred or shift to other parties or by financial derivatives (Don M, C. 2016). Hence, only systematic risks are priced and compensate to the investor.

There is four characteristic associated with systematic risk (Don M, C. 2016.).

1.Objectively, systematic risk obstinately exists and unable to diversified.

2.Complexity, systematic risk is consists of multiple factors include in both macroeconomic and microeconomic, domestic interest rate, exchange rate, inflation, business cycle, political and so forth.

3.Systematic risk indicates a lost.

4.Uncertainty, investors is unable to predict the risks of the market precisely and the severity when it occurs.

In CAPM model, term Beta is to use to measure systematic risk, where systematic risk depends on the correlation between the asset and the market. Therefore, Beta is indicating the movement of securities relate to market move and how do securities correlate to the market. In addition to Beta, Fama and French also suggest that the systematic risk factor would also account the relative size of the company and relative book-to-market value of the enterprise (Fama and French, 1992). The study of Fama and French also found that the past returns could be explained better with their model than with other models available at that time, this is the most notably, the capital asset pricing model. Those factors mentioned above is known as three factor of return generate model of CAPM. However, the simplest and widely used return generate model is the single-index model, which only systematic risk, beta is considered, expressed by following formula.

The single-index model indicates that the expected return of security is risk-free rate add to the sensitivity of the security relate to market Multiply by the risk premium. The expression is simple, and only indicated the systematic risks.

The CAPM has following assumption to make the model validate (L, John. 1965).

1.The investor is risk-averse, utility-maximising, and rational individuals.

2.Markets are frictionless, including no transaction costs and no taxes.

3.Investors plan for the same single holding period.

4.Investors have homogeneous expectations or beliefs.

5.All investments are infinitely divisible.

6.The investor is price takers.

However, as CAPM from a single-index model is to give an investor early