Question

Explain the difference between the traditional correlation approach and the capital asset pricing model (CAPM) approach to evaluating the risk of an individual financial asset.

Answer 1

The Capital Asset Pricing Model (CAPM) describes the connection between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of these assets and price of capital.The formula for calculating the expected return of an asset given its risk is as follows:

​ERi​=Rf​+βi​(ERm​−Rf​)

where:

ERi​=expected return of investment

Rf​=risk-free rate

βi​=beta of the investment

(ERm​−Rf​)=market risk premium​

Financial correlations measure the relationship between the changes of two or more financial variables over time. For example, the prices of equity stocks and fixed interest bonds often move in opposite directions: when investors sell stocks, they often use the proceeds to buy bonds and vice versa. In this case, stock and bond prices are negatively correlated.

Correlation is measured on a scale of -1.0 to +1.0:

• If two assets have an expected return correlation of 1.0, that means they are perfectly correlated. If one gains 5%, the other gains 5%. If one drops 10%, so does the other.
• A perfectly negative correlation (-1.0) implies that one asset's gain is proportionally matched by the other asset's loss.
• A zero correlation indicates the two assets have no predictive relationship.