Risk/Return Analysis and Capital Asset Pricing Model
In investment, there are certain forms of risk which exist. There is the diversifiable and non-diversifiable risk. Fama (1968) says that certain scenarios are useful in explaining better whether a risk is diversifiable or non diversifiable.
These include if;
- There’s a substantial unexpected increase in inflation.
This is a non diversifiable risk. Firstly, the inflation increase is not expected. This means that the investor cannot think of diversifying. Secondly, inflation is a single risk thus making it affect all investment areas. This means even if you invest in different areas, inflation will end up biting. Despite the fact that there are items which are used to hedge inflation, it is practically hard to diversify inflation.
- There’s a major recession in the U.S.
This is a diversifiable risk. With a major recession hitting the US economy, it is possible to diversify such risk. This is because other economies outside the US are stable and not affected by the recession per-se. This means that an investor can look outside the US’s economy for investment. This means that the assets invested outside the United State’s economy will be able to give the investor good returns since the economies invested in would be thriving. This will ensure that the assets being affected in the US’s economy would be covered by the ones performing well in economies outside the United States.
- A major lawsuit is filed against one large publicly traded corporation.
Things affecting a large corporation such as lawsuits in which an investor has put his or her money are diversifiable. It is important for the investor to find out and make a decision on how to manage the investment in such a corporation.
- ER(i)=Rf(i)+B(i)- E(Rm)-Rf)
Expected Rate of Return on the Market Portfolio =ER (i) =1.26
Risk Free Rate=RF=0.8-0.9-0.1=-0.2
- Owning half of the portfolio, the beta would be 0.5. This is because Beta is usually a representation of the non-diversifiable risk. This is usually referred to as the systematic or market risk.
The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model is useful to both the corporations and investors. This pricing model gives certain messages to both investors as well as corporations. This model is able to give useful information regarding the type of investments possible as well as the possible expectations
The Capital Asset Pricing Model and Investors
The Capital Pricing Model is usually very useful in giving results based on reality. This happens as a result of considering only the systematic risk. This is because most investors eliminate the unsystematic risk in their investment decision. This is after investing in well diversified portfolios. According to Rubinstein (2006), the Capital Asset Pricing Model is able to give the investor a good view of the relation between the required return and the systematic risk in an investment. This model also gives an indicator of the issues surrounding the entire stock market. This means that the Capital Asset Pricing Model is able to give the investors indicators whenever red flags occur. The CAPM ensures that the investor makes the best investment decisions on time (Arnold, 2005).
The Capital Asset Pricing Model and Corporations
Corporations are also able to benefit from the messages that the capital asset pricing model offers them. This is because this pricing model gives information regarding various elements of the business. Firstly, the Capital Asset Pricing Model is able to give indications regarding the level of equity of the company relative to the systematic risk in the market (Dyson, 2010). This is very useful in giving the corporation an opportunity to plan on equity management. It therefore gives a good opportunity to know the reasonable value of the corporation’s equity at any given time.
Arnold, G (2005). Corporate financial management. Prentice Hall.
Dyson, J.R. (2010). Accounting for non-accounting students. 8th ed. Harlow: Pearson Education.
Fama, F. (1968). Risk, Return and Equilibrium: Some Clarifying Comments. Journal of Finance Vol. 23, No. 1, pp. 29–40.