Question

1. What is the relationship that constitutes the foundation of the Capital Asset Pricing

Model?

2. What are the vital functions that this relationship serves?

3. List two (2) of the assumptions that lead to the basic version of the CAPM

4. Explain what the “Market Portfolio” is.

5. Explain what the Security Market Line is.

Answer 1

1. The Capital asset pricing model is based on the relation between the beta of a security, a risk free-asset and equity risk premium or market risk premium multiplied by the beta of the security. The relationship between these variables serves the foundation of the CAPM model.

2. The vital function this relationship serves is that in this model risk of a security consist of systematic risk and non-systematic risk and non-systematic risk can be reduced by diversifying your portfolio hence only systematic risk is relevant and it is measured by the beta of the security. The required return on any security consist of the risk-free rate and risk premium for that security.

3. Two assumptions of the CAPM model are:

· No transaction cost.

· All investors have homogenous expectation regarding the input factors in the calculation of the model.

4. Market portfolio is a term that is used for a portfolio where the composition of stocks in the portfolio is similar to the market (here the word market is used as a proxy for an index). The return from a market portfolio is similar to the return expected from the market and normally the beta of market is taken to be 1 so the market portfolio also has beta equal to 1.

5. Security market line is a graphical representation of the expected return and risk of the CAPM model. It shows different level of systematic risk and expected return from that security. The systematic risk is plotted on the X-axis and the expected return is plotted on the Y-axis. The systematic risk is measured in terms of beta.