Extract of sample Investing in Portfolios and CAPM
If the investor chooses alternative 1 and invests all the money in Evergreen, then he can earn a return of 13.8%. Since Evergreen is a safe company, therefore the standard deviation of returns is quite low and risk coefficient is only 0.11. One must keep in mind that by investing in this company, the investor is foregoing chance of earning high returns. In other words, the investor is foregoing chance of earning high returns for increased safety by investing in this company. On the other hand, in the case of alternative 2, if the investor decides to invest in more dynamic of the two companies ACE limited, then the investor is foregoing safety of investment for high returns. This will enable the investor to earn a return which is as high as 25%. However, the risk coefficient and standard deviation for this investment is also higher at 0.31 and 7.6% respectively. A third option is to invest in the form of an equally weighted portfolio. In this case, the returns have increased from what the investor could earn by investing solely in Evergreen and at the same time the high risk of investing in Ace Ltd has also been reduced. The returns have increased from 13.8% to 19% and at the same time risk coefficient has decreased from 0.31 to 0.2. In the case of alternative 4, the investor will invest heavily in Evergreen and take very small exposure in ACE. This option is probably the worst alternative because the returns of this option are not very high, but the risk has greatly increased to 0.47. In the above scenario, we can see that the returns have increased when the investor has decided to invest in portfolios and at the same time risk coefficient has gone down. This tells us that diversification leads to lower risk and high return. However, one must keep in mind that diversification only minimizes one type of risk that an investor faces. There is another kind of risk which is known as systematic risk and it cannot be eliminated no matter how well diversified the portfolio is. Hence, there is always some chance of investors losing money even if the money is invested in the form of a portfolio. The correlation coefficient above shows that the investment in Evergreen and Ace is negatively correlated. A shrewd investor always try to invest in companies that are negatively correlate so that the downward trend in the returns of one business can be offset by the increased returns on the other investment in the same portfolio. However, since these two investments are not perfectly correlated, the portfolio is not well balance and some side will be higher than another and investor can face periods of high returns or loss depending on the market situation. It can be concluded from studying the above alternatives that it is wise for investors to not to take large exposures on one single stock. The investors should try to construct portfolios that should give equal or close weightage to all the companies in the portfolios in order to enjoy the benefits of risk diversification. If there is one company in the portfolio which has higher weightage than the other companies ten the portfolio’s performance will be highly dependent on that one company and benefits of diversification will disappear. TASK 2: Capital Asset Pricing Model is a tool to
Running Head: Investing in Portfolios Investing in Portfolios and CAPM Name Date Alternative 1: Entire Investment in Evergreen Alternative 2: Entire Investment in Ace Limited: Alternative 3: Invest half the funds in Evergreen and half the funds in ACE: Alternative 4: 90% Investment in Evergreen and 10% investment in ACE: j The above calculation sheds light on the fact that it is very important to invest in portfolios rather than taking exposure in one type of investment…
The sophisticated financial instruments and the integration of the worldwide markets have further widened the investment choices for an investor. This makes it increasingly important to evaluate the risk associated with an investment in order to derive the maximum financial gains by bearing the least possible risk.
Thus, it is the relevant measure of risk. As risk increases so does the required rate of return and market risk premium is the difference between the required rate of return on a portfolio minus the risk free rate multiplied by the beta of that stock. RPs = (km –krf) bs The basic assumptions of CAPM are that investors choose among portfolios to maximize their return and wealth.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
It also endows with the validation for the tendency of passive investing in huge index mutual funds. No doubt, it's impossible to get rid of all the risk irrespective of our diversification in investments. Naturally each investor deserves avelocity of return to assist him for taking on risk.
because of this assumption, it is assumed that there is no information asymmetry in the market, implying that all investors have the same publicly available information concerning securities in the market. Thus, since investors have similar information, the models assume that
It should be kept in mind that the information should be free of risk factors (Altwies & Reynolds, 2010).
Risk rate of the asset is determined in the market. It consists of an average rate of risk calculated by the investors in the market who are acquiring
Normally, they devote their due care on the average and deviation of their returns from the investment to minimize the deviation of the return on the portfolio given an anticipated return and maximize anticipated
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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