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The CAPM is useful to investors from two standpoints -- time value of money and the risk associated with the money invested. The time value of money is revealed by the free rate risk and represents the compensation investors will receive for having invested their money in the respective share, for a specific period of time. The risk of the investment is revealed by the second part of the formula -- beta x (expected market return -- risk free rate) -- and it unveils the compensation the investor should receive for making an investment with the given levels of risk involved. In achieving this desiderate, the Capital Asset Pricing Model assigns a beta, which helps compare the returns of the asset to the market, over the given time period, and to the market premium. Basically, "the CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should...
In this order of ideas, the most useful application of the Capital Asset Pricing Model for economic agents is that it reveals the strength of their organizational shares. This in turn reveals the company's financial health and points to matters which necessitate improvement. Finally, it reveals the market attractiveness of their stocks and as such the ability to increase their capitals through shareholders' equity.
References:
2009, Diversifiable Risk, Answers, http://www.answers.com/topic/diversifiable-risk last accessed on September 3, 2009
2009, Diversifiable Risk, Money Terms, http://moneyterms.co.uk/diversifiable-risk / last accessed on September 3, 2009
2009, Capital Asset Pricing Model, Investopedia, http://www.investopedia.com/terms/c/capm.asp last accessed on September 3, 2009
Capital Asset Pricing Model (CAPM) Basically, a diversifiable risk can be taken to be that risk which is largely limited to a given sector or security. On the other hand, a risk which affects the entire assets or liabilities class is referred to as an un-diversifiable risk. While it is possible to eliminate or reduce a diversifiable risk through diversification, the same cannot be utilized when it comes to the elimination
CAPM For each of the scenarios below, explain whether or not it represents a diversifiable or undiversifiable risk. Explain your reasoning a. It is announced that a company is under investigation from the federal government for fraudulent accounting practices. This represents a diversifiable risk. This risk is unsystematic and is unique to the company that is under investigation. Hopefully, if this stock was part of a portfolio, the effect of this risk
Finance Any Asset Pricing Theory forms the basic foundation of finance theory, in that it deals with the value of any asset under unknown or uncertain circumstances. The relationship between an asset and its price is the mainstay of the asset pricing theory: the lower the price, the poorer the expected performance. The Arbitrage Pricing Theory derives from this theory. The basic idea in the APT theory is that any sort
Investor Diversification Some investment assets have a diversifiable risk and some have an undiversifiable risk involved. Diversifiable risk is specific to a particular security or sector, so its impact on a diversified portfolio is limited to that particular security (moneyterms.co.uk). For example, a financial crisis in a country can cause diversifiable risk on the investments pertaining to the financial institutions. Undiversifiable risk is the tendency of stock prices to decrease, which
CAPM The first scenario represents a diversifiable risk. The rate of inflation has an effect on the whole economy, but the nature and direction of that effect is something that will be different for each firm. Some firms may suffer more than others from the effects of a higher rate of inflation, depending on their business model, their capital structure and their strategy. In addition, inflation rates are a national phenomenon.
Risk There are two kinds of risk that a company faces. Systematic risk is risk that is inherent in the economy. This risk is generated largely by external factors to the company, such that the company has little control over these factors. This type of risk is faced by all companies (or most of them) within the economy and as a result it is very difficult to diversify systematic risk away.