Capital Asset Pricing Model Essay
Trident University International
FIN301 - Principles of Finance
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2. …show more content…
Main message of the CAPM to investors
The total risk of a portfolio (indeed of a security) consists of two parts: Market (or systematic) risk and Unique (Unsystematic or firm-specific) risk. Diversification reduces the unique risk; but the market risk cannot be diversified away. Therefore, the Capital Asset Pricing Model (CAPM) advocates that investors should not expect to be compensated (expect more profit) for taking on unique risk as it can be diversified away, but they can expect to receive higher returns for taking on more market risk.
Main message of the CAPM to corporations
The major conclusion of CAPM is that expected return on an asset is related to its systematic and not to its total risk or standard deviation. Its systematic risk is given by its beta coefficient (beta ). An asset's beta is a measure of its co-movement with the market index.
CAPM (Capital Asset Pricing Model equation is:
r A= r f + beta A (r m - r f) where rf is the risk free rate, rm is the return on market portfolio. rA is the required return on a risky asset like equity.
Corporations often use CAPM to help estimate the cost of equity financing, which is in turn, an important component of the weighted average cost of capital