Finance Engineering

Finance Engineering

Introduction

Capital Asset Pricing Model (CAPM ) is a widely used tool for measuring the volatility of particular stocks and comparing them against the market . Higher volatility of a stock signifies higher risk , and hence justifies a higher return expectation . This looks at some important questions connected to the CAPM

Factors affecting expected return under CAPM

The Capital Asset Pricing Model (CAPM ) is used to calculate the cost of capital or expected return from a particular stock by computing the extra return required for the particular stock to compensate

for the extra risk associated with it . The formula for calculating the expected return is as follows

ra rf (rm - rf

where

rf Risk free return

rm Market return (Economy Professor , 2008

Thus expected return under the CAPM depends on three factors , which are given below

The Risk free return : This is measured as the return that can be expected from an investment that is not subject to market fluctuations Usually the interest rates on Bonds issued by the government of a country are taken as the benchmark , and the return on the government bond for a period comparable to the life of the investment being considered is taken as the risk free return . The significance of the risk free return is that it provides the starting point for determining the required rate of return , which is arrived at by adding the premium required to compensate for the additional risk represented by the stock being considered

The expected market return : This is the return that the entire market is providing , on an average , on all the stocks in the market put together The role played by this figure in the calculation of expected return from a stock is to provide a benchmark on the additional premium that is required for the market as a whole . Risks are of two types - systematic and unsystematic or specific . Diversification can be used to eliminate or reduce specific risk , but the systematic risk still remains even if all the stocks in the market are included in a portfolio . The expected market return represents the additional premium that the investor expects to compensate for this risk over the rate of the risk free investment (McClure , 2008

Beta : This measures the relative volatility of a particular stock as against that of the entire market . Beta is measured through a statistical computation that considers the periodic market rates of the particular stock in question , and the corresponding composite value of all the stocks in the market . In practice this composite value is taken to be a standard market index such as the Dow Jones or NYSE index . Beta is used to calculate the correction that needs to be applied on the expected market return to arrive at the expected return of a particular asset to compensate for the extra volatility , and hence extra risk of the asset in question . A beta value of 1 indicates that the volatility (and hence risk ) of the asset in question...