Question

Based on the class text book- Principles of Managerial Finance by Gitman & Zutter - Chapter 5-Time Value of Money and Chapter 8- Risk and Return and other additional readings,  

Explain the models of Risk and Return.

Answer 1

Answer :-

Capital asset pricing model (CAPM):-

Capital asset pricing model (CAPM) describes the linear relationship between risk-return trade-off for the securities / portfolios. CAPM method distinguishes between risk of holding a single asset and holding a portfolio of assets. There is a trade-off between risk and return. A graphical representation of CAPM method is the security market line, (SML), which indicates the rate of return required to compensate at a given level of risk. The risks to which a security / portfolio is exposed are divided into two groups, diversifiable and non-diversifiable.

The diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified securities. Whereas, the non-diversifiable risk is attributable to factors that affect businesses like interest rate changes, inflation, political changes etc. As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk is the only risk a business should be concerned with. The CAPM method is solely concerned with non-diversifiable risk.

In CAPM method, the non-diversifiable risks are assessed in terms of beta coefficient, β, through fitting regression equation between return of a security / portfolio and the return on a market portfolio.

Required return (CAPM formula) = Risk free rate of return + Beta * (Market rate of return - Risk free rate of return).

CAPM method provides a conceptual framework for evaluating any investment decision where capital is committed with a goal of producing the future returns.

CAPM method is developed with the main goal to formulate the return required by investors from a single investment or a portfolio of assets. The required rate of return is defined as the minimum expected return needed so that investors will purchase and hold an asset.