Question

1. Share Market & Risk and Return

2. a) What is the purpose of CAPM?

3. b) What are the assumptions of CAPM and are they reasonable?

4. c) How does portfolio diversification relates to the CAPM?

5. d) How do we proxy for systematic risk?

6. e) What is the outcome of CAPM?

Answer 1

(A) The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security.Ra = Expected return on a security

Ra= Rrf + ( Ba*{Rm-Rrf})
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Ra=Expected return on a security

(B) Basic assumptions of the CAPM model are as follows.

Markets are ideal—no transaction fees, taxes, inflation, or short selling restrictions.
All investors are averse to risk.
Markets are highly efficient. All investors have equal access to all available information.
All investors can borrow and lend unlimited amounts under a risk-free rate.
Beta coefficient is the only measure of risk.
All assets are absolutely liquid and infinitely divided.
The amount of available assets is fixed during a given period of time.
Markets are in equilibrium. All investors are price takers, not price makers.
Return of all available assets is subject to normal distribution function.

We can say some assumptions reasonable and some not reasonable in these days.

(C) In the CAPM, investors hold diversified portfolios to minimize risk. ... Investors holding diversified portfolios are exposed only to systematic market-related risk. Therefore, the relevant risk in the market's risk/expected return trade-off is systematic risk, not total risk.

(D)

The Beta of a stock or portfolio measures the volatility of the instrument compared to the overall market volatility. It is used as a proxy for the systematic risk of the stock, and it can be used to measure how risky a stock is relative to the market risk. When used as a proxy to measure systematic risk, the β value of a portfolio can have the following interpretation.

When β = 0 it suggests the portfolio/stock is uncorrelated with the market return.
When β < 0 it suggests the portfolio/stock has an inverse correlation with the market return.
When 0 < β < 1 it suggests the portfolio/stock return is positively correlated with the market return however with smaller volatility.
When β = 1 it suggests that the portfolio return has a perfect correlation with the market portfolio return.
When β > 1 it suggests that the portfolio has a positive correlation with the market, but would have price movements of greater magnitude.

(E) Capital Asset pricing Model has never shown strong empirical evidence. Major drawback of CAPM model is its hypothetical assumptions. CAPM also fails to explain the various other effects Empirical evidences shows that CAPM has not been able to predict accurate return even in long term investments.