Chapter 20 -Capital Asset Pricing Model

Question 1

What are the types of risk

Answer 1

UnSystematic risk (company specific risk)

Systematic risk (market risk)

It is the systematic risk that determines the return share holders require because unsystematic risk can be eliminated with diversification of portfolio but systematic risk cannot be

Question 2

What Is systematic risk (market risk)

Answer 2

It is due to general economic factors such as rates of inflation or exchange rates.

All companies are effected by systematic risk as it isn’t within the companies control.

Levels of risk changes depending on sector, eg a company dealing with foreign currencies has higher risk than that just dealing with gbp

Systematic risk can not be removed by investors but level depends on type of business

Question 3

What is unsystematic risk (company specific risk)

Answer 3

Due to factors within company

Eg new managing director (if good profits rise if bad profits may fall) or maybe poor labour relations (our workers are going on strike)

This type of risk can be removed by investors by creating portfolio of shares (spread money into different companies)

Question 4

How is systematic risk measuresd

Answer 4

It is measured by the B (beta) and is measured against the stock exchange (market) as a whole

If a share has a

B of 1 = then it is 1 x risky as market (remember B is the market as a whole, the index) and therefore the same riskiness as market

B > 1 = more risky than market

B < 1 = less risky than market

B of 0 = then it has zero risk or we say it’s “risk free”

Question 5

How to apply the beta (B)

Answer 5

Q plc has a a beta of 1.5 (1.5 x riskier than market as a whole) and the market is giving a return of 12% (average market return) and the risk free rate of 5% (government securities are the least risky investment)

work out the required return from Q plc

Firstly the market premium is 7% meaning that what the market is offering on average is 7% higher than the risk free option (12-5)

For Q we know risk free is 5% but we want more and we know ours is 1.5 x riskier than the market premium of 7% which is 10.5% therefore we want 15.5%

To get rate of return=

Risk free + market premium x B

Question 6

What are the limitations of capital asset pricing model

Answer 6

1. How do you accurately determine the riskiness of a project
2. CAPM only looks at a 1 year period whereas projects usually last for longer