Capital Asset Pricing Model (CAPM)

Question 1

Explain CAPM

Answer 1

1. because non-systematic risk can be
   eliminated by diversification, it is not rewarded.
2. It is the sensitivity of the security to the
   market that is the appropriate measure of risk.
3. Only systematic risk taken into account.

Question 2

Explain Beta

Answer 2

1. The sensitivity of a security relative to the market.
2. The market has a B of 1
3. if Companies B is 1 it moves directly with the market
4. If companies B is >1 it exaggerates the market movements
5. If <1 it is more stable than the market

Question 3

What is the CAPM equation

Answer 3

E(Ri) = Rf +Bi (Rm - Rf)

E(Ri) - Expected return
Rf - Risk free rate
Bi - Beta of the investment
Rm - Return on market portfolio

Question 4

Explain the Assumptions of CAPM

Answer 4

1. investors are rational, risk adverse + making decisions purely based on risk + return
2. all investors have same holding period
3. no one individual can affect market price
4. no tax
5. Information is free and for all
6. investors can borrow and lend at risk free rate.

Question 5

Limitations of CAPM

Answer 5

1. what to use as risk free rate?
2. what is the market portfolio?
3. suitability of Beta - not always predictable
   
   • use historical info