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In: Finance
How is the Capital Asset Pricing Model related to regression? (Select all that apply) a. regression...
How is the Capital Asset Pricing Model related to regression? (Select all that apply)
a. regression provides an estimate of alpha which is an input in CAPM
b. regression is a waste of everyone's time
c. regression provides an estimate of alpha, which is an output of CAPM
d. regression provides an estimate of beta, which is used in CAPM
Solutions
Expert Solution
a. regression provides an estimate of alpha which is an input in CAPM
d. regression provides an estimate of beta, which is used in CAPM
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.
nvestors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate they can use to find the value of an asset.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share today that pays a 3% annual dividend. The stock has a beta compared to the market of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 8% per year.
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