Question

Imagine that you are a new college professor developing your first lecture on the Capital Asset Pricing Model. How would you explain the concept to your incoming freshman class?

In your discussion, include the relationship between the expected rate of return on a particular investment and the expected rate of return for a portfolio with multiple investments. What is the relationship between systematic and unsystematic risk? Analyze how the risk relationship related to the beta of an investment.

Answer 1

1. CAPM

Capital Asset Pricing Model (CAPM) is used to calculate the expected rate of return by using the Systematic risk, market rate, risk free rate of return on investment. This model focuses on Paying premium over risk free rate to investers willing to take the risk, higher the risk higher would be the Expected rate of return.

CAPM formula:

Expected Rate of return {E(X)} = Risk Free Rate (Rf) + [{Market Rate(Rm) - Risk free rate(Rf)} X Beta(B)]

2. Relation between Expected Rate of return for a portfolio vis-a-vis Individual stocks.

Once you are aware of E(X) for all the individual stocks then Expected return on portfolio is found out using the weighted average of the E(X). Since portfolio as a whole will also follow the same CAPM.

3. Relation between systematic and unsystematic risk

"Systematic Risk" is inherent in any Equity market. It is a risk that can't be ruled out. For instance, Market will move in a particular direction based on outcome of a FED meet. One cant eliminate the risk of outcome of FED meet.

"Unsystematic Risk" is the one which is linked to a particular industry, company etc. Corrective actions can be taken if investor wants to avoid this risk. For e.g. Avoid the investment in pharma stocks based on one's estimation or expectation that Government will bring in the unfavourable regulations. It is also called as Diversifiable risk.

Total Risk = Systematic Risk + Unsystematic Risk.

4. Beta of an investment

Beta is the of the systematic risk for a particular risk. i.e. By how much % the particular stock fluctuates for 1% fluctuation in Stock market (due to Systematic risk). Beta is found using the regression analysis and it only considers the systematic risk. Since the Diversifiable risk is unforseen and can be eliminated thus we do not consider it for computing the Beta.