The document discusses the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. It defines key terms like systematic risk, diversifiable risk, beta, and the CAPM formula. The CAPM holds that the required return on an asset is equal to the risk-free rate plus a risk premium based on the asset's systematic risk as measured by its beta coefficient. Only systematic risk that can't be eliminated by diversification is relevant to the expected return. Diversifiable risk can be reduced or eliminated by holding a diverse portfolio.
The document discusses the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. It defines key terms like systematic risk, diversifiable risk, beta, and the CAPM formula. The CAPM holds that the required return on an asset is equal to the risk-free rate plus a risk premium based on the asset's systematic risk as measured by its beta coefficient. Only systematic risk that can't be eliminated by diversification is relevant to the expected return. Diversifiable risk can be reduced or eliminated by holding a diverse portfolio.
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CAPITAL ASSET PRICING MODEL AND MODERN PORTFOLIO THEORY
The document discusses the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. It defines key terms like systematic risk, diversifiable risk, beta, and the CAPM formula. The CAPM holds that the required return on an asset is equal to the risk-free rate plus a risk premium based on the asset's systematic risk as measured by its beta coefficient. Only systematic risk that can't be eliminated by diversification is relevant to the expected return. Diversifiable risk can be reduced or eliminated by holding a diverse portfolio.
The document discusses the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. It defines key terms like systematic risk, diversifiable risk, beta, and the CAPM formula. The CAPM holds that the required return on an asset is equal to the risk-free rate plus a risk premium based on the asset's systematic risk as measured by its beta coefficient. Only systematic risk that can't be eliminated by diversification is relevant to the expected return. Diversifiable risk can be reduced or eliminated by holding a diverse portfolio.
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CAPITAL ASSET
PRICING MODEL AND
MODERN PORTFOLIO THEORY
CAPITAL ASSET PRICING MODEL (CAPM)
is a model based on the propositions that any stocks required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification. it provides a general framework for analyzing riskreturn relationships for all types of assets. do not use total risk in evaluating these relationship, which is measured by standard deviation as a risk measure, but only one part of total risk called systematic risk.
TWO MAJOR COMPONENTS
Diversifiable Risk Undiversifiable Risk
DIVERSIFIABLE RISK also called unsystematic risk or company risk. is that part of a securitys risk caused by factors unique to a particular firm. can be diversified away because it represents essentially random events. sources include lawsuits, strikes, company management, marketing strategies and research and development programs, operating and financial leverage., and other events that are unique to the particular firm.
UNDIVERSIFIABLE RISK also called systematic risk or market risk. is that part of a securitys risk caused by factors affecting the market as a whole. cannot be eliminated by diversification because it affects all firms simultaneously. the only relevant risk and is affected by such factor such as wars, inflation, interest rates, business cycles, fiscal and monetary policies.
Figure 23-1. Effect of diversification on Unsystematic and
Systematic Risk
ILLUSTRATION Case 23-1. Suppose a particular stock has a risk-free rate of 5%, a rate of return on the market of 12% and a beta (quantity of risk) of 1.5. What would be the investors required rate of return? Solution: required rate of return = 5% + (12%- 5%) 1.5 = 15.5%
THE BETA COEFFICIENT CONCEPT
BETA is a measure of the sensitivity of a securitys return relative to the returns of a broad-based market portfolio securities. B is defined mathematically as the ratio of the covariance of returns security (i), and market portfolio (m), to the variance of returns of the market portfolio. measure the comovement between a stock and the market portfolio. The tendency of a stock to move with the market is reflected in its beta coefficient (b), which is a measure of the stocks volatility relative to that of an average stock.
THE BETA COEFFICIENT CONCEPT
COVARIANCE is an absolute statistical measure of the extent of two variables, such as securities move together. AVERAGE RISK defined as one that tends to move up and down in step with the general market as measured by some index.
RELATIONSHIP BETWEEN RISK AND
RATE OF RETURN The CAPM expresses risk-return relationship using beta as the relevant risk measure. CAPM states that the required rate of return on a risky asset consists of the risk-free rate plus a premium for systematic risk. CAPM Formula: ri = rf +bi (rmrf) Where: ri = required (or expected) return on security, i rf = expected risk-free rate of return rm= expected return on the market portfolio bi = beta coefficient of security, i
RELATIONSHIP BETWEEN RISK AND
RATE OF RETURN 1. Risk-free rate of return(rf) is the return required on a security having no systematic risk and is generally measured by the yield on short term Treasury securities such as treasury bills. (a). The risk-free rate consists of two components: a real rate that excludes any inflationary expectations, and an inflation premium that equals the expected inflationary rate. (b). The risk-free rate changes in the same direction and by the same amount as the inflation premium changes. Since the risk-free rate is part of a securitys required rate of return, a change in inflationary will
RELATIONSHIP BETWEEN RISK AND
RATE OF RETURN 2. Risk-premium, bi (rm- rf) is the return required in excess of the risk-free rate and is due to systematic risk. Part of the risk premium is the market risk premium (rm- rf), which is the additional return expected for holding a market portfolio of average riskiness (b = 1.0). The risk premium for a specific security will differ from the market risk premium if the individual securitys beta does not equal 1.0.
