Question

4. Describe any two of the following terms and give an example of why each is important: a. Beta  b. CAPM c. WACC

Answer 1

a. Beta

There are two types of Risk

Systematic Risk - It is the volatility of a stock on account of economy wide factors. It affects all stocks in the same direction with unequal sensitivity. It is the risk which is inherent to the market and it cannot be avoided through diversification. Systematic Risk of a stock referes to sensitivity of the stock to the economy. The systematic risk is measured in terms of Beta.

For example - If beta of a stock is 1.5, it means for a 1% change in the market return, stock return is expected to change by 1.5% in the same direction. Beta is important as it measures systematic risk which cannot be avoided even by holding a diversified portfolio.

Unsystematic Risk - It is the volatility of a stock on account of internal company specific factors. This risk can be avoided through diversification. The greater the number of stocks in the portfolio the greater is the chance of Unsystematic Risk getting cancelled out.

b. CAPM

CAPM or Capital Asset Pricing model states that risk can be decomposed into Systematic and Unsystematic risk. As Unsystematic risk is diversifiable the only relevant risk is systematic risk captured by beta.

Assumptions of CAPM

• Investors are rationale
• Investors have uniform single period investment horizon
• Investors have homogeneous expectations
• Markets are perfectly competitive
• Markets are in equilibrium.

The Investors invest in the most diversified portfolio i.e. market portfolio and combine that with Risk free rate borrowing or lending. In short, all investors lie along the capital market line and enjoy the highest sharp ratio.

CAPM helps in calculating the Required Rate of Return for an investor. It is the minimum return that an investor would want from his investment.

The formula for calculating Re or Required rate of return is

As per Capital Asset Pricing Model (CAPM)

Re = Rf + (Rm-Rf) β

Where Re = Required rate of return

Rf = Risk free rate of return

Rm – Market Return or Expected Return on Market

β – Beta of the stock