Question

Describe CAPM and how it can be used to to manage portfolio risk...?

How is CAPM used by investors to manage portfolio risk as well as how they can create portfolios tailored to the investors exact risk tolerance level..?

Include Sources... Base answers upon the work of Markowitz and Sharpe/Litner..

Answer 1

Capital Asset Pricing Model

As per CAPM model Risk management is more important than return management. Risk may be of loss of return or loss of main investment made.

Investment can be made in a single security or in a portfolio. Both have different risk. In portfolio risk further can be divided in two parts i.e. systematic risk and unsystematic risk.

Systematic risk is related with market and measured as Beta. Lower Beta shows lower risk than the market. Higher Beta shows higher risk than the market. Beta equals to 1 show that the security is as risky as the market.

Unsystematic risk related with security and can be reduced by diversification.

Formulas

For Individual Security:-

Return= Risk free return +Beta (Market Return- Risk free Return)

Beta= Covariance (Return of investment. Return of market)/Variance (Return of Market)

Portfolio Beta = Individual weight of security in portfolio (X) Beta of Security

Use of CAPM to manage Portfolio Risk:-

CAPM Model can be used to manage portfolio risk as portfolio beta can be measured through it further the desired level of Beta of either can be increased or decreased with the help of this model.

Like If it risk is too high weightage of high risky securities can be reduced by selling it and by way of acquisition of low risk securities and vice versa in case of risk is too low.

Use of CAPM by investor

Each individual investor have their own preferences like someone wants higher return, some may prefer security of investment. CAPM help them to measure risk and return, by use of this investors can create their portfolio better as per their requirement.

This model has certain assumptions:-

1. Efficiency of market- full information available
2. Investors knows their preferences
3. All assets are divisible
4. Borrowing are easy to investor
5. No Brokerage or other charges exists and other assumptions

Hence use of this model has risk of above assumptions, therefore should be used carefully.

Sources of this Model

Harry Markowitz is initial inventor of this model than Jack Trey nor, William F sharpe, John linter and Jan Mossin use his work and present the model.