Question

1. Write a brief paragraph describing the CAPM model.

2. Write a brief paragraph describing Beta and its role in CAPM.

3. Using the CAPM formula, calculate Race Co.’s required return given that the common stock has a beta of 1.8, the risk-free rate is 2.0 percent, and the market return is 10.0 percent

Answer 1

1	CAPM attempts to measure the risk of a security in the Portfolio sense.
	It is an economi model that determines how securities are priced in the
	market place.
	It considers the required rate of return of a security on the basis of its
	contribution to total portfolio risk.
	The main idea of CAPM is that only undiversifiable risk is necessary in
	the determination of expected return on any asset.
	According to CAPM, in equilibrium, return of a portfolio is equal to risk free
	plus a risk premium that is proportional to its beta.
	The CAPM is represented mathematically by
	Expected Return
	= Risk Free Rate + Beta*(arket Return - Risk Free Rate)
	= Risk Free Rate + Beta*Market Risk Premium
2	Beta is a measure of systematic risk of an asset relative to that of
	Market Portfolio.
	It depends only on Non-divesifiable risk and it measures non-diversifiable
	risk of a stock or a portfolio.
	Therefore Beta plays major role in CAPM model, as according to
	CAPM model only Non-diversifiable risk is necessary in determination
	of expected return.
3	Race Co's Required Return
	= Risk Free Rate + Beta*(arket Return - Risk Free Rate)
	= 2% + 1.80*(10% - 2%)
	= 2% + 1.80*8%
	= 2% + 14.40%
	= 16.40%