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1 What is the relationship between risk and return as per CAPM?
Wiki User
∙ 11y ago
The CAPM has implications for:
- Risk-return relationship for an efficient portfolio
- Risk-return relationship for an individual asset or security
- Identification of under and over-valued assets traded in the market
- Pricing of assets not yet traded in the market
- Effect of leverage on cost of equity
- Capital budgeting decisions and cost of capital and
- Risk of the firm through diversification of project portfolio.
Assumptions of CAPM:
- Individuals are risk-averse.
- Individuals seek to maximize the expected utility of their portfolios over a single period planning horizon.
- Individuals have expectations that are homogeneous. This essentially means that they have similar subjective estimates of the means, variances and covariances among returns.
- Investors can borrow and lend freely at the riskless rate of interest.
- The market is perfect. The assumption is that there are no taxes, no transaction costs, securities are completely divisible and the market is also competitive.
- The quantity of risky securities in the market is given.
Elements of the CAPM:
There are 2 elements of the CAPM. They are:
- Capital Market Line and
- Security Market Line.
- Capital Market Line:
It depicts the risk-return relationship for efficient portfolios. It serves two functions. Firstly, it depicts the risk-return relationship for efficient portfolios available to investors. Secondly, it shows that the appropriate measure of risk for an efficient portfolio is the standard deviation of return on the portfolio. - Security Market Line:
It is a graphic representation of CAPM and describes the market price of risk in capital market. Risk averse investors seek risk premium to invest in risky assets. The risk is variability in return and the total risk consists of both systematic risk and unsystematic risk. Generally, the investor can avoid unsystematic risk by diversifying his investment in portfolio. But systematic risk is unavoidable. The market compensates for systematic risk only, according to the capital market theory. The level of systematic risk in an asset is measured by the beta coefficient, represented by the symbol β. The CAPM links beta to the level of required return.
CAPM model: Ke
= Rf
+ β (Km
- Rf
)
Where:
Ke
=Expected return or cost of equityRf
=Risk-free rateβ=Beta or Beta coefficientKm
=Expected return on market portfolio (or) equity market required return
Security Market Line (SML)
Example 1:
Given: Required rate of return on a portfolio = 17%; Beta = 1.1; Risk-free rate = 5%. What is the expected rate of return on the market portfolio?
Ke
= Rf
+ β (Km
- Rf
)
17% = 5% + 1.1 (Km
– 5%)
Km
= 0.159 or 15.9% or 16%.
Example 2:
Given, the risk-free rate is 8%; Expected return on market portfolio = 14%; Beta = 1.25. Investors believe that stock will provide an expected return of 17%. What is the expected return as per CAPM and the "alpha" of the stock?
Expected return as per CAPM=0.08 + 1.25 (0.14 - 0.08)=>0.155 or 15.5%.Alpha of the stock = 17.00% -15.55%=>1.5%
(The excess return over the expected return according to the CAPM is termed as "alpha").
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∙ 11y ago
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Relationship between risk and return?
risk is pre-stage for return...
The risk-return relationship for each financial asset is shown on?
the security market line
If CAPM is valid then a stock having more volatile returns must have larger expected return than a stock with less volatile returns to compensate for higher risk borne?
no
If beta is 1.8 risk free rate is 5 and expected market risk premium is 12 what is the cost of equity?
5.216 according to CAPM
Discuss the relationship between financial and decision making and risk and return would all financial manageres view risk return tradeoffs similarly?
there is a direct relationship between financial decision making and risk and return. each financial decision made by the financial manager will have implication for the overall risk of the firm and its potential returns. All financial decisions are ultimately subjective in nature regardless of the amount of objective information collected as part of the decision making process. as a result, not all financial managers view risk return trade offs similarly. however it is expected they such decision making will be consistent with the goal of the investors that the financial manager represents. good luck......
What are the deficiencies of CAPM as an explanation of the relationship between risk and expected return?
One major deficiency of CAPM is that it assumes a linear relationship between risk and expected return, implying that assets with higher risk will always yield higher returns. However, in reality, this relationship may not hold true as investors may require additional compensation for taking on higher risk. Additionally, CAPM relies on the use of a single factor, the market risk premium, to explain all variations in expected returns, which may not adequately capture the complexity of real-world market conditions. Lastly, CAPM assumes that all investors have the same expectations and agree on the same inputs, which may not reflect the diverse range of beliefs and opinions in the market.
What is the Capital Asset pricing model used for?
The Capital Asset Pricing Model is a pricing model that describes the relationship between expected return and risk. The CAPM helps determine if investments are worth the risk.
What happens when you get negative market returns can you use that to compute the required rate of return using CAPM?
A negative market return means that there has been a loss on investments because stocks have gone down. CAPM is a model that describes the relationship between risk and expected return and could be used to try to foresee negative market returns.
How can the CAPM be used to estimate the cost of capital for evaluating real investment decisions by a firm?
C.A.P.M describes the relationship between beta, market risk and expected return of the investment. In order to use the CAPM to estimate the cost of capital for this investment decision, we need to historical data, extract their levered beta, determine the appropriate manner to average them, and apply the resulting risk to the investment's CAPM.
Relationship between risk and return?
risk is pre-stage for return...
What is the CAPM formula?
CAPM: kj = krf + B (market risk premium) = krf + B (km + krf) Note: B is Greek letter beta, which is the relationship between market returns and your portfolio.
When it comes to investing what is the usual relationship between risk and reward?
When it comes to investing, one general relationship between risk and reward is that taking more risk is associated with a greater return. However, in many cases there is no relationship between the two. For example, even though stocks tend to have a higher return than bonds, taking that risk does not guarantee a better return.
What is the relationship between financial decision making and risk and return?
plz quote me the answer of the above question
What does beta risk do to the determination of the cost of capital?
Beta risk arrived through regression technique (regressing stock return and market return) is the key data used to arrive at the cost of equity using CAPM model. The risk premium is calculated using Beta, and risk free return is added to it in order to arrive at cost of equity.
What is risk return relationship?
The risk return relationship is a business concept referring to the risk involved in exchange for the amount of return gained on an investment. These two factors are directly proportional to each other, meaning the more return sought, the higher the risk that is undertaken.
The risk-return relationship for each financial asset is shown on?
the security market line
What is the relationship between financial decision making and risk and return Would all financial managers view risk-return trade-offs similarly?
return is a reward gained from investing or the reward from employing assets in a company. risk is the degree of uncertainty of possible return generated from an investment
