Question

Topic #4: Risk and Return

The Capital Asset Pricing Model (CAPM) is an accepted method of determining a risk-adjusted rate of return on equity and requires some basic inputs in order to perform the calculation.

Required:

1. a) Undertake some basic research to find out when the CAPM was first developed and by whom. Outline your findings including details of the journal / textbook most closely associated with the CAPM.

2. b) The CAPM requires the determination of a risk-free rate of interest (rf), with government securities most commonly used as a proxy for the risk-

   free rate of interest. Outline whether it should be short / medium or long-term government securities that would best be used as the relevant

   proxy for rf.

3. c) There are often considerable differences in the reported betas of individual company shares included on a securities / stock exchange.

   Undertake some basic research to provide example of where information on company betas can be accessed. Select any 3 securities / stock exchange listed companies and discuss the reasons why they have differing reported betas.

   That is, is it likely that companies operating across a number of industries will have different betas simply because of these different industries?

Please discuss this case and explain your opinion by following the requirement.

Answer 1

Answer no a :

CAPM was first developed by Jack Treynor in 1961-62, William Sharpe in 1964, John Lintner in 1965 and Jan Mossin in 1966 independently. William Sharpe, Harry Markowitz and Merton Miller received the Nobel Memorial Prize in Economics for their work on CAPM in the year 1999. The CAPM was first introduced by Jack Treynor in the year 1962 in the article named "Toward a Theory of Market Value of Risky Assets". William Sharpe published his article on CAPM in the Journal of Finance in the year 1964, the article was named - "Capital asset prices: A theory of market equilibrium under conditions of risk"

Answer no b :

The choice of risk free rate depends on the expected investment tenure of the Investor. If the investor is willing to hold the investment for the long term, generally, Long term Risk free rate ( 10 year yield on Government securities) is considered. In practice, generally, short term risk free rate is considered as 3 months yield on Government securities. The most relevant choice of risk free rate depends on the expected investment tenure of the Investor.

Answer no c :

We shall select the following three companies for examining the beta. First, we shall select Tesla, second we shall select PFizer and third we shall select Wells Fargo. The beta of Tesla is 1.91, the beta of PFizer is .66 and beta of Wells Fargo is 1.07. Beta depends on the systematic risk of the security and is measured by the percentage change in asset prices to percentage change in market Index. Beta is low for defensive industries like pharma and high for cyclical industries like Auto. This is due to the fact that the economic results of cyclical industries are more volatile as compared to defensive industries and hence, their prices and returns are highly volatile and hence, there beta is high. On the other hand, defensive stocks has low volatility of economic result and hence, their prices are also less volatile as compared to the market and hence, the low beta. Hence, it is likely that companies operating across a number of industries will have different betas simply because of the differece in the business risks as well as financial risks of the companies.