Question

Explain beta concept and how can you find the beta of an asset or portfolio? Identify key components of the CAPM model. What is SML? What method would you use to establish risk and return relationships?

Answer 1

Beta is a measure of market risk and standard deviation is a measure of firm specific risk. managers typically deal with firm specific risk and market risk subjectively when they are evaluating a potential project.

Beta is calculated by using Correlation between stock return and market return and standard deviation of market return and standard deviation of stock return.

Beta is calculated below using following formula:

Beta = Correlation × (Standard deviation of Stock / Standard deviation of Market)

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

Security Market Line

security market line (SML) shows the relationship between required rate of return and level of risk (beta). security market line helps to determine the risk aversion level among investors. the flatter the slope of the security market line the higher the level of risk aversion.