Question

1. Discuss the capital asset pricing model, including systematic and unsystematic risk and return, and how to avoid risk.

2. Discuss the three forms of the efficiency market hypothesis.

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Answer 1

1.

Capital Assets pricing model

Capital Assets pricing model is the method uses to determine required rate of return of an asset. This method uses, Risk free rate, market return and beta (a measure of market risk) to determine required rate of return on an asset. Market risk premium is calculated by market return and risk-free rate.

Beta is a measure of level of risk in investment. when beta of the company is changed that is level of risk change then the cost of capital of company is also change.

Capital assets pricing model formula for calculation of cost of capital is mention below:

Cost of capital = Risk free rate + (Market Return - Risk free rate) × Beta

Systematic risk

Systematic risk, also known as "market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire market or entire market segment. Also, referred to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price.

Beta coefficient is measure of systematic risk.

Unsystematic risk

Unsystematic risk also called diversifiable risk is risk associated with specific firm. This risk is arise due to firm-specific events, such as strikes, lawsuit, regulatory actions, and loss of a key account and contingent liability. A firm can reduce this risk by proper diversification of assets, product mix, better relation with labor union.

Standard deviation is measure of unsystematic risk.

2.

Efficient market hypothesis

Efficient market hypothesis is investment theory that states nobody can earn higher return than market. There are three forms of Efficient market which is mention below:

1. Week form Efficient market

In Week Form Efficient market, future stock price is not depending on past stock price. So, in Week Form Efficient market future stock cannot be predicted. In short term investor can earn excess return than market but in long term investor cannot earn higher return in market.

2. Semi strong form Efficient market

In semi strong form of market efficient, market price of stock adjusts quickly to any information. So, in Semi strong form Efficient market nobody can earn higher return than market if he uses public information for trading. Insider trader who has more information than market earn higher return than market.

3. Strong form Efficient market

The strong form of the efficient market hypothesis suggests that all stock related information is publicly available to all investor and invest make decision rationally for make investment decision. In efficient market, required rate of return is equal to expected rate of return and market value of stock is equal to book value of stock.