Question

1. Discuss the capital asset pricing model, including systematic and unsystematic risk and return, and how to avoid risk.

2. Discuss the three forms of the efficiency market hypothesis

Answer 1

Answer

1.

combining securities into portfolios reduces risk. When securities are combined, a portion of a stock's variability in turn is canceled by complementary variations in the returns of other securities. The total risk is the sum of unsystematic risk and systematic risk. The capital asset pricing model's (CAPM) assumptions result in investors holding diversified portfolios to minimize risk.

Capital asset pricing model:

If the CAPM correctly describes market behavior, the measure of a security's risk is its market-related or systematic risk. The CAPM provides insight into the market's pricing of securities and the determination of expected returns. Therefore, it also has a clear application in investment management. The model relates to a firm's cost of equity capital and the cost of equity for the market as a whole. The tool will arm you with a simple equation to assist you in optimizing your investment decision and the creation of your portfolio.

Systematic and unsystematic risk and return:

Some of the companies in your portfolio may experience unanticipated adverse conditions, like an unannounced strike. This immediate adverse condition may be offset by unexpected good fortune of other firms in your portfolio. However, stock prices and returns tend to move in tandem, and not all variability can be eliminated through diversification.

It is preferable to divide a security's total risk into a portion that is peculiar to a specific firm and can be diversified away (called unsystematic risk) and that portion that is market related and nondiversifiable (called systematic risk):

Total risk =
Unsystematic risk (diversifiable risk, firm-specific) + Systematic risk (nondiversifiable risk, market-related)

Avoid risk:

You must be compensated for taking on risk with your hard-earned money. Risky securities are priced by the market to yield a higher than expected return than low-risk securities. The risk premium is necessary to induce investment in the security. The market is dominated by risk-averse investors. You do not want to lose your money. There must be a positive relationship between risk and expected return to achieve equilibrium. The expected return on a riskless security like a Treasury bill is risk-free.

The expected return = Risk-free return + Risk premium
R_S = R_F + R_P

In other words, the expected return will vary with the risk premium based upon the flat risk-free return. The curve can be linear or exponential, depending upon the risk premium investment.

2.

Efficient market hypothesis (EMH) is a principle that believes that :

1) this stock is always in balance

2) it is impossible to win an investor consistently in the market.

This hypothesis states that the securities are generally valued in this sense that the price reflects all the publicly available information on each security.

There are three variants or levels of market efficiency. The weak form of EHH indicates that all the information contained in the previous stock price movements in the current market prices is fully reflected. If this was true, then information about the recent trends in stock prices would not be of any use in selecting stocks.Semi-strong form of EHH indicates that the current market price reflects all publicly available information, therefore, if semi-strong form is present, then it will not be happy to touch the annual report because the prices of the market are contained in such reports Good or bad news will also be adjusted when news comes first. The strong form of EHH indicates that the current market value reflects all relevant information, whether publicly available or not.If this is a form, insiders will find it impossible to earn unusually high returns in the stock market.