The Capital Asset Pricing Model

The Capital Asset Pricing Model

a. There’s a substantial unexpected increase in inflation.

  1. This risk can be classified as undiversifiable risk because it is common to all assets and liabilities in the entire economy. All assets and liabilities will be impacted by the inflation in different magnitudes but all will be affected. Careful allocation of assets and liabilities can however minimize the impact of this risk because the degree of impact may vary among different classes of assets (Khan & Fiorino, 1992).
  2. There’s a major recession in the U.S.
    This is risk is undiversifiable risk because it affects all assets in the entire economy. It is a risk that will affect the returns of all assets in the companies in the U.S. Careful allocation of assets and liabilities can however minimize the impact of  this risk because the degree of impact may vary in classes of assets in different sectors of the economy. One sector may be affected more than another. However all assets will be affected (Khan & Fiorino, 1992).
    c. A major lawsuit is filed against one large publicly traded corporation.
    A major law suit against a large publicly traded corporation can be classified as diversifiable. This is a risk arising from a law suit which is a unique event to the company. The company can completely eliminate this risk by hiring the best lawyers to ensure the court judgement delivered is to their favor (Khan & Fiorino, 1992).
    2. 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.
    The CAPM equation  is as follows;

E(Rj) = Rf + (E(Rm) – Rf)betaj

Where;

E(Rj) = expected return on the jth risky asset

Rf = rate of return on a riskless asset

E(Rm) = expected return on the market (all economic assets) portfolio

betaj = beta of the jth risky asset

Therefore; 12%=4%+(E(Rm)-4%)1.2=10.7%  (Khan & Fiorino, 1992)

  1. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset “j” is 0.8.

Using the same formula in 2 (a) above;

9%=Rf+(10%-Rf)0.8=5%
c. What do you think the Beta (?) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.

Generally the betas of many companies are normally around one but not more than three. This means that many securities beta tend to rise and fall with the same percentages that market indices fall. If I owned more than half of all the stocks traded in major exchanges the beta of my portfolio would be three but certainly not less than one. The reason for this is that I will be able to effectively allocate assets in less risky areas or sectors in which undiversifiable risk has less impact in terms of returns than others based on my analysis of the general economic environment (Rosenberg & Guy, 1995).
3. In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?

The main “message” of the capital asset pricing model is that investors do not have to lose their investment funds by sticking with securities that are falling due to adverse economic conditions. Investors can use CAPM  to determine returns of various securities to choose which securities to invest in and which ones to diversify from. An investor is able to mitigate undiversifiable risk through the use of capital asset pricing model. Investors can use CAPM to decide which assets to hold and which one to sell and how much to sell and hold to maximize returns (Rosenberg & Guy, 1995).

 

References

Khan, A. M., & Fiorino, D. P. (1992). The capital asset pricing model in project selection: A

case study. The Engineering Economist, 37(2), 145. Retrieved from

http://search.proquest.com/docview/206727807?accountid=45049

Rosenberg, B., & Guy, J. (1995). Prediction of beta from investment fundamentals. Financial Analysts Journal, 51(1), 101. Retrieved from http://search.proquest.com/docview/219118485?accountid=45049

 

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