Capital Asset Pricing Model, Essay Example

Large fire severely damages three major U.S. cities.

The risk is diversifiable since the risk is not systematic, this risk can be spread by investing indifferent cities. Fire is not a risk which is common to all markets, therefore investing in different cities and towns will reduce the risk to the investor.

A substantial unexpected rise in the price of oil.

This is a non diversifiable risk since it affects the whole market; the investor cannot be able to reduce his/her risk through investing in different portfolios or areas. These risks cannot be avoided because it is caused by factors which affect the firms systematically.

A major lawsuit is filed against one large publicly traded corporation. Risk and diversification

This type of risk is diversifiable since it is caused by factors affecting specific firm. Since this event is essentially random its effect on portfolio can be eliminated by diversification. The investor can distribute the risk by building up his/her portfolios.

Ri= Rf + Bi (Rm – Rf)

10% = 3% + 1.5 (Rm – 3%)

10% = 3% + 1.5Rm – 4.5%

0.1= 0.03 + 1.5Rm – 0.045

0.1 – 0.03 + 0.045 = 1.5Rm

1.5 * 0.115=1.5Rm/1.5

Rm = 7.7%

Rj= Rf + Bj (Rm – Rf)

0.14 = Rf + 1.5 (0.12 – Rf)

0.14 – 0.18 = Rf – 1.5Rf

Rf = 0.04/.05

Rf = 0.08 or 8%

These securities hold systematic risk which is beyond the investor’s control; the beta will depend on how sensitive the returns of a security will be affected by the market portfolio. Since this portfolio is well diversified the beta = 1. Since the security is neither aggressive nor defensive it is said to be neutral.

The main message received by investors through the use of CAPM is very vital to them. The investors get informed on how to evaluate the viability of every investment given by different companies. By the investors valuing stocks, they can determine the degree of the risk associated with each investment and the anticipated returns within a specified time period. The investors get the message on the market risks which assist them when building or adding their portfolio. If investors asses the market risks well and couple it with the expected returns it becomes essential to them in arriving at a very essential valuation which will help them arrive at well-versed decision.

The information received by corporate by use of CAPM do benefit them so much, for they get the knowledge about the risks involved in their investments as well as the returns. The corporate become well positioned in terms of unsystematic and systematic risks, of which unsystematic can be eliminated through diversification of their investments. A corporate is able to evaluate an investment reduce risks and increase its returns by diversification e.g. investing in different areas or securities. Incase of systematic risks, corporate can be able to measure the risks involved and take precautions.

References

Pandey, I. M. (1999). Financial Managent.Ed 8^th .New Delhi: Vikas Publishing House PVT    Limited.

Groppelli, A.A, & Nikbakht, E. (2006). United Kingdom: Barron’s Education Series.