Question

QUE // (a) what is the capital assets pricing model and what does it try to help us do ?

(b) what does BETA tells you

   (c) what risk can be diversified away and what is undiversifiable risk ?

   (d) what does it mean to diversify

Answer 1

Answer:

(a) Capital Asset Pricing model - The CAPM explains the relationship between the expected return, non-diversifiable risk and the valuation of securities. It considers the required rate of return of the security on the basis of its contribution to the total risk.It is based on the premise that the diversifiable risk of a security is estimated when more and more securities are added to the portfolio. However, the systematic risk can not be diversified and is correlated with that of the market portfolio. All securities do not have same level of systematic risk. Therefore, the required rate of return goes with the level of systematic risk.The systematic risk can be measured by Beta.. Under CAPM, the expected return from security can be expressed as:

Expected return on security = R_f + Beta (R_m - R_f)

The model shows that expected return of a security consist of a the risk free rate of interest and the risk premium. The CAPM when plotted on graph paper is called security market line. A major implication of CAPM is that not only every security but all portfolios to must plot on SML. This implies that in an efficient market all securities are expected to yield returns commensurate with their riskiness measured by Beta.

This method helps us in investment decision problem when one choses to setup a portfolio, the expectation of the return has to be studied carefully. The idea is to get better understanding of an asset returns and try to diversify the risk.

(b)what does BETA tells you - Beta is a measure of investments systematic risk. It measures systematic risk associated with an investment in relation to total risk attached with market portfolio. A security with Beta greater than 1 is called the aggressive security, with Beta less than 1 is called defensive security and with Beta 1 is called the neutral security.

Beta = (Correlation co-efficient of portfolio with market X into standard deviation of securities) / standard deviation of market

If Beta equal to 1, it indicates that the securities is equally more risky as compared to market i.e. if market fluctuates by 1% then the return on security also fluctuates with 1%.

If Beta is more than one , it indicates that the security is riskier than market. Suppose is equal to 1.4 it means if the market fluctuation is one percent, the expected return on security will fluctuate by 1.4 %

(c) what risk can be diversified away and what is undiversifiable risk ? - There are two types of risk :systematic risk and unsystematic risk.Systematic risk refers to that portion of risk in return caused by the factors that affect the price of the security. Therefore, it can not be diversified.

Unsystematic/Undiversifiable risk refers to that portion of risk which is caused due to factors unique related to a firm and industry. The unsystematic risk is the change in the price of stocks due to factors which are particular to the stock for example if excise duty or custom duty of Viscos fibre increases, the price of the cost of synthetic yarn declines.The unsystematic risk can be eliminated or diversified. Diversifiable risk can be of two types : Business risk & Financial risk

(d) what does it mean to diversify - Diversification means reduction of unsystematic risk from the portfolio. Systematic risk is particular to a stock and unique to an industry. Events such as inflation, war and fluctuating interest rates are inherent in the firms operation and can be reduced by diversification.