Question

Investments

Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)

Answer 1

The price of a security  is set by the stock market. We will use the CAPM for describing how to calculate value or price of individual security. This model takes into account two components -

1. component for time value of money or value that compensates the investors for placing money in any investment over time. The risk-free rate is used which can be the yield on government bonds like U.S. Treasuries.

2 component for risk premium and this calculates the value the investor needs for taking on additional risk. We calculate this by taking a risk measure (beta) and the market premium (Rm-rf): the return of the market in excess of the risk-free rate.

The formula of CAPM is

R_a = Risk free rate + Risk Premium

R_a = R_f + B_a ( R_m - R_f )

R_a is the expected return for assets

R_f is the risk free rate typically rate of interest on government security or tresury bonds

R_m is the expected market return

B_a is the beta of the security or the risk associated with the security. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market, and the correlation between the two.

( R_m - R_f ) is the market premium or the return of the market in excess of the risk-free rate.

If this expected return does not meet or beat the required return, then the investment should not be undertaken.