Question

Please provide your thoughts about the below paragrahp regarding stocks and returns:

Asset Pricing Model and how investors can use it to research stocks they are looking at investing in. In other words, the return that investors expect to earn on a risky asset equals the risk-free rate plus a risk premium (Smart, Gitman & Joehnk). Investors expect a return on an investment higher then they can receive with a risk free asset. Historically the 10-year US Treasury bond has been the benchmark of a risk free asset. Since the government of the United States has the ability to print money it is assumed that they will always pay their debts. Also US treasury securities have been some of the most sought after risk free investments in the world. We discussed the concept of diversification and how that can lower the overall risk of a portfolio. You will never be able to completely eliminate risk so investors will require a higher return for riskier assets. The market classifies riskiness of an investment by the beta.

Beta is a measure of undiversifiable risk. A security’s beta indicates how the security’s return responds to fluctuations in market returns, which is why market risk is synonymous with undiversifiable risk (Smart, Gitman & Joehnk). We will use the beta in the CAPM equation to quantify the expected return that an investor will require on two stocks below:

The CAPM equation is the Risk Free Rate + Beta (Expected Market Return – Risk Free Rate). The part of the equation in the parentheses is classified as the risk premium.

Ford Motor Company

2.8% + .85 (8.0% - 2.8%)= 7.22%

Bank of America

2.8% + 1.62 (8.0% - 2.8%)= 11.22%

As the beta increases the return required by an investor also increases. The farther above 1.0 that a beta increases the riskier that security is. As discussed earlier beta is the measure of how sensitive a security is to fluctuations in the market. A security with a beta of .5 is one half as responsive as the market. A beta of 1.0 is the market benchmark. A beta of 2.0 is twice as responsive as the market. This can mean that you can reap greater returns or greater losses then the overall market. This is the risk that an investor is trying to quantify with this model and beta can be useful tool. It is important to note that the CAPM does have some limitations. Betas are usually based on historical data and this could cause some issues. Company’s risk profile can change often due to market conditions so beta should be only a tool in the toolbox not the only answer.

Answer 1

Asset pricing model is one of the tools used by prospective investors to calculate the expected return on stocks or securities. The basis of asset pricing model is that any risky security should yield more return than the risk free rate. Risk free rate refers to the interest rate on US debt. Since USA can print dollar bills to meet its financial obligations, its debt is theoretically risk free. Any other security should yield a higher return than return on US debt since investors need to be compensated for the risk of investing in a "non risk free" asset. It is therefore important for investors to quantify risk associated with securities and appropriate expected return on those securities.

Beta is an important measure to quantify the risk associated with a security. It measures the sensitivity of a stock's return relative to the overall market returns. A beta of 1 indicates that the stock moves in sync with the market whereas beta higher than 1 indicates higher volatility of stock returns. A drawback of Beta is that it is based on historical data meaning it is not forward looking and therefore it should be used cautiously. Beta is used in the CAPM (Capital Asset Pricing Model) to calculate the expected return of a stock. CAPM formula is:

Expected Return on a stock = Risk Free Rate + Beta of Stock * (Expected Market Return - Risk Free Rate)

Therefore if the risk free rate is 3%, beta of a stock is 2 and expected market return is 10% then the expected return on that stock is 3+2*(10-3) = 17%