Question

Question 4

1. Describe the Capital Asset Pricing Model (CAPM).

(4 marks, maximum 200 words)

2. Using the CAPM derive the required annual rate of return on the market portfolio given the following information:

• The current rate of return on treasury bills is 3.5%.
• The required annual rate of return on a security with a beta of 1.5 is 12.2%.

3. Distinguish between
   1. Systematic, and
   2. Unsystematic risk                            

(4 marks, maximum 200 words)

Total for the question 10 marks

Answer 1

Answer : Capital Asset Pricing Model (CAPM) describes the risk-return tradeoff for securities. It describes the linear relationship between risk and return of the securities.CAPM measures relationship between the expected return and the risk of security.CAPM is also used for analyzing securities and pricing them given the expected rate of return and cost of capital . Formula for calculating Expected Return or Cost of Equity under CAPM is as Follows:

Cost of Equity or Expected Return = Risk free Rate + Beta ( Return from Market - Risk free Rate)

where Risk Free Rate is the valueof investment that have a return with zero risks.

Beta  is a measure of a stock’s risk and measures the fluctuation of in price changes in relation to the overall market.

(Return from Market - Risk free Rate) also known as Market Risk Premium is additional return over risk-free rate, to compensate investors who invests in a riskier asset.

Therefore CAPM is very useful throughut the finance for calculation of Expected return from investors point of View or Cost of Equity from Company's point of View.

Answer : Calculation of Return from Market Portfolio

Required Annual Return = Risk free Rate + Beta ( Return from Market - Risk free Rate)

12.2%= 3.5% + 1.5 * ( Return from Market - 3.5%)

8.7 % = 1.5 ( Return from Market - 3.5%)

==> Reurn from Market = (8.7% / 1.5 ) + 3.5%

= 9.3%

Answer : Distinction between Systematic and Unsystematic Risk

Systematic Risk refers to variability of returns on stocks or portfolio associated with changes in return on the market as whole. It arises due to risk factors that affect the overall market such as changes in nation's economy ,tax reforms etc. These are risks that affect the securities overall and cannot be diversified. This risk is common to entire class of assets. The value of investment may decline over a given period of time period simply because of economic changes or events that impact larger portions of market to underperform at different times . This is called market risk .

Unsystematic Risk however, refer to risk unique to particular company . It can be reduced or avoided through diversification. This is the risk of price change due to unique circumstances of specific security as opposed to overall market. This risk can be virtually eliminated from a portfolio through diversification.