Valuation Techniques - CAPM

Question 1

Give the capital asset pricing model formula and describe its components.

Answer 1

RR = RFR +  B(ERR - RFR)
Where:
RR = Required rate of return
RFR = Risk-free rate of return
B = Beta, a measure of volatility
ERR = Expected rate of return for a benchmark for the entire class of the asset being valued.

Question 2

Define “beta”.

Answer 2

Beta is a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment.

Question 3

Identify and describe the three possible alternative values of beta.

Answer 3

Beta (B) = 1: The individual asset being valued changes in the same proportion as the entire class of the asset being valued; the asset has average systematic risk for the entire class.

Beta (B) > 1: The individual asset being valued changes greater than the entire class of the asset being valued; the asset is more volatile than the entire class.

Beta (B) <1: The individual asset being valued changes less than the entire class of the asset being valued; the asset is less volatile than the entire class.

Question 4

What are the major assumptions and limitations of the capital asset pricing model (CAPM)?

Answer 4

• All investors have equal access to all investments and are using a one period time horizon.
• Asset risk is measured solely by its variance from the asset class benchmark.
• There are no external costs - commissions, taxes and so on.
• There are no restrictions on borrowing or lending at the risk-free rate of return.
• There is a market and market benchmark for all asset classes.
• CAPM uses historical data.

Question 5

Define/describe the capital asset pricing model (CAPM).

Answer 5

The capital asset pricing model (CAPM) is an economic model that determines the relationship between risk and expected return and uses that measure in assigning value to securities, portfolios, capital projects, and other assets.