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Financial Economics 2012- Quantitative Methods II, Statistics Project
Finance & Accounting
Pages 4 (1004 words)
Capital Asset Pricing Model Introduction An essential question in finance is how the risk of an investment should affect its return. It is for this reason that the Capital Asset Pricing Model (CAPM) was devised. Capital Asset Pricing Model (CAPM), is a theory that explains how asset pricing is affected in the marketplace.
The CAPM gives an understanding about the kinds of risks that affect the return through assessment of these risks. The model uses the beta of a specific security, the risk-free rate of return, and the market return to compute the required return of an investment to its expected risk. The CAPM Model and its uses The formula for the beta coefficient of stock is given by: Beta Coefficient of Stock (?) = ?rm / ?2m ?rm = the Covariance between the returns on asset i and the market portfolio ?2m = the Variance of the market portfolio This beta value serves as an important measure of risk for individual assets (portfolios) that is different from ?2m, it measures the non-diversifiable part of risk. It is an indirect measure which compares the systematic risk (risk which cannot be eliminated by portfolio diversification) associated with a company’s shares with the unsystematic risk (risk which can be eliminated by portfolio diversification) of the capital market as a whole. If a beta value of 1 is obtained, the systematic risk associated with the shares is the same as the systematic risk of the capital market as a whole. ...
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