Question

1. Discuss the capital asset pricing model, including systematic and unsystematic risk and return, and how to avoid risk.

2. Discuss the three forms of the efficiency market hypothesis.

Answer 1

CAPM's starting point is the risk-free rate – typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

the formula of CAPM is given as -

return = risk free rate + beta ( return of market - risk free rate)

where return of market - risk free rate is also referred as market risk premium.

and beta is the only relevant measure of a stock's risk.

Unsystematic risk which is also known as specific risk is the type of uncertainty that comes with the company or industry you invest in.for example , sudden strike by a employyes of company in which we are trading is a example of unsystematic risk.Unsystematic risk can be reduced through diversification

systematic risk consists of the day-to-day fluctuations in a stock's price where volatility is a measure of risk.Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be mitigated only by being hedged.

2) The efficiency market hypothesis considers how much information about a company and its stock price is available to their investors.thus the three forms of efficiency market hypothesis are as follows

a)weak form - in this form all new public information (earnings reports, financial statements, etc) and private information (new products, upcoming earnings, legal issues) may or may not be available to investors,and only historical price information is available.

b)semi strong form - in this form  in addition to the historical price data available in the weak form of market, public information about a company is available to investors and is incorporated into the current price of the stock.

c) strong form - in this form allnon-public insider knowledge is factored into the current price of the stock.