Question

If we add more factors into the one-factor asset pricing model, what happens to the required returns, increase or decrease? If the expected future cash flows of the financial securities remain the same, will that increase or decrease the current market price? Why?

Answer 1

Answer(1):

One-factor asset pricing model is CAPM. Capital asset pricing model is used to calculate the required return of an asset. This describes the relationship between systematic risk and expected return from assets. It takes into consideration the BETA that is measurement of systematic risk.

Formula: Re = Rf + Beta (Rm - Rf)

Where;

• Re is expected return of the security
• Rf is risk free rate
• Rm is expected return of market.
• Beta is a systematic risk measure.

If we add more factors into this formula, expected return will increase.

Answer(2):

If the expected future cash flows of the financial securities remain the same, that will decrease the current market price because future cost will increase on the basis of time value of money concept and in the same proportion if cash flow does not increase then stock price will come down. People will not buy the shares of that company whose future cash flow will remain same and will not increase.