Topic 9: The CAPM and risk Flashcards
What is the difference between systematic and unsystematic risk?
Systematic risks are external factors e.g interest rates, conflicts, recessions.
Unsystematic risks are unique factors that only affect your business/industry e.g weather, new competition, Poor management.
Unsystematic risk can be diversified away (Investors invest in lots of industries, if one is doing bad, the others will keep teh whoel investment up).
What is CAPM and how to calculate it? Formula given.
On the formula sheet.
E(ri) = Required rate of return
Rf = Risk free factor
E(rm) = Market rate of return / return on market portfolio.
(E(rm) - Rf) = Equity risk premium/market risk premium.
Bi = Beta of the sercurity/measure of risk of that sercurity.
Ke = Cost of equity.
This helps us determine the required rate of return for investors by including systematic risk.
What assumptions are required for CAPM?
Beta is based on past returns - we are calculating an estimate for the future and using past info which could be misleading.
Investors are well diversified - an investor may not be well diversified and want compensation for unsystematic risk.
Constant Rf - The risk free rate is the same which is not correct as it can change from any external factors.
Only considers total return - it doesn’t take into account if the investor prefers dividends or capital gains.
Perfect markets - assumes everyone has perfect information and no transaction costs so its unrealistic.
What are the different types of beta in CAPM and when do we use them?
Asset beta - reflects systematic risk (Business only risk).
Equity beta - reflects systematic risk and financial risk.
If a question says quoted beta it means equity beta.
What is the process to find out what the asset beta is from the equity beta of a proxy company and vise versa?
Step 1 - We need to find a proxy company so we can use their quoted beta.
Step 2 - We need to de-gear the equity beta of the proxy to establish the asset beta we do this by using the asset beta formula (using the proxy companies beta)
Step 3 - We need to re-gear the asset beta from step 2 to establish the new equity beta (same formula) using our companies gearing.
Step 4 - Use regeared equity beta in CAPM to calculate the project specific discount rate / risk adjsuted cost of equity.
