Part 1 '' A Measurement of Risk 1.1 Risk 1.2 Capital Asset Pricing Model The estimation of systematic risk (or ‘beta’) is central to the implementation of the capital asset pricing model (CAPM) for researchers and practitioners. Markowitz (1952) argued that investors should be concerned with holding efficient portfolios, that is, a portfolio offering the highest expected return for each level of risk. Sharpe (1964) and Lintner (1965) took Markowitz’s work one step further to develop the CAPM to explain the relationship between systematic risk and expected return in financial markets. The CAPM is denoted by the following equation: The CAPM is used to determine the expected return on any security (E(ri)), which is consistent with the notion that price (or expected return) of a security is derived by its market risk. Investors are only concerned with market risk as it is assumed that rational investors hold a portion of the market portfolio, that is, a well-diversified portfolio. Since systematic risk is the crucial determinant of an asset’ s expected return, we use beta as a way of measuring the level of systematic risk for different investments and is given by the following equation. Beta is calculated by dividing the covariance of the excess returns on the stock and excess returns on the market, divided by the variance of excess returns on the market. Excess returns are returns above or below the risk-free rate. According to the methodology of Frino et al (2006) (all formulae are provided under appendix 1.1), the first step in calculating the beta of a security is to collect historical data and calculate a sequence of excess returns on a stock and excess returns on a market. This is illustrated in appendix 1.1 using weekly stock-price data for Rio Tinto, the All Ordinaries Accumulation Index and 10-yr bond yields. Because bond yields are expressed on an annual basis they must be converted to a weekly rate or return (by simply dividing by 52)....

...Model commonly known as CAPM defines the relationship between risk and the return for individual securities. CAPM was first published by William Sharpe in 1964. CAPM extended “Harry Markowitz’s portfolio theory” to include the notions of specific and systematic risk. CAPM is a very useful tool that has enabled financial analysts or the independent investors to evaluate the risk of a specific investment while at the same time setting a specific rate of return with respect to the amount of the risk of a portfolio or an individual investment. The CAPM method takes into consideration the factor of time and does not get wrapped up over by the systematic risk factors, which are rarely controlled. In this research paper, I will look at the implications of CAPM in the light of the recent development. I will start by attempting to explain and discuss the various assumptions of the CAPM. Secondly, I will discuss the main theories and moreover, the whole debate that is surrounding this area more specifically through the various critics of the CAPM assumptions.
When Sharpe (1964) and Lintner (1965) proposed CAPM, it was majorly seen as the leading tool in measuring and determining whether an investment will yield negative or positive return. The model attempts to expound the relationship...

...Regular-BetaCAPM to Downside-BetaCAPM
Qaiser Abbas
Corresponding Author, Professor Department of Management Sciences COMSATS Institute of
Information Technology Chak Shahzad, Park Road, Islamabad
E-mail: qaisar@comsats.edu.pk
Usman Ayub
Assistant Professor and PhD Scholar COMSATS Institute of Information Technology
Chak Shahzad, Park Road, Islamabad
E-mail: usman_ayub@comsats.edu.pk
Shahid Mehmmod Sargana
Assistant Professor, COMSATS Institute of Information Technology
Chak Shahzad, Park Road, Islamabad
Syed Kashif Saeed
PhD Scholar, COMSATS Institute of Information Technology
Chak Shahzad, Park Road, Islamabad
Abstract
CAPM has come a long way and has passed the time-test and eventually is fast coming out
as a winner despite the onslaught of both, APT and multi-factor CAPM. The bottom line is
that CAPM is needed, dead or alive. If so, it does not mean that CAPM stays as “CAPM”.
Downside risk in recent times has caught the eyes of researchers. Downside-betaCAPM
(DCAPM) based on downside risk is being thought a fast replacement to CAPM. It
captures almost all the features of CAPM but let goes conditions of normality and
investor’s preference of both upside and downside risk. With evidence pouring in from all
corners of the world...

...CAPMCAPM provides a framework for measuring the systematic risk of an individual security and relate it to the systematic risk of a well-diversified portfolio. The risk of individual securities is measured by β (beta). Thus, the equation for security market line (SML) is:
E(Rj) = Rf + [E(Rm) – Rf] βj
(Equation 1)
Where E(Rj) is the expected return on security j, Rf the risk-free rate of interest, Rm the expected return on the market portfolio and βj the undiversifiable risk of security j. βj can be measured as follows:
βj = Cov (Rj, Rm)
Var (Rm)
= σj σm Cor jm
σ2 m
= σj Cor jm
σm
(Equation 2)
In terms of Equation 2, the undiversifiable (systematic) risk (βj) of a security is the product of its standard deviation (σj) and its correlation with the market portfolio divided by the market portfolio’s standard deviation. It can be noted that if a security is perfectly positively correlated with the market portfolio, then CML totally coincides with SML.
Equation 1 shows that the expected rate of return on a security is equal to a risk-free rate plus the risk-premium. The risk-premium equals to the difference between the expected market return and the risk-free rate multiplied by the security’s beta. The risk...

...pricing model (CAPM)
Using the Capital Asset Pricing Model, we need to keep three things in mind. 1 there is a basic reward for waiting, the risk free rate. 2 the greater the risk, the greater the expected reward. 3 there is a consisted trade off between risk and reward.
In finance, It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. 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 not be undertaken. The security market line plots the results of the CAPM for all different risks (betas - a model that calculates the expected return of an asset based on its beta and expected market returns.)
Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17%=(3%+2(10%-3%)).
Risk of a...

...Is CAPMBeta Dead or Alive? Depends on How you Measure It
Jiri Novak*
* Uppsala University, Sweden E-mail: jiri.novak@fek.uu.se October 2007 Abstract: The CAPMbeta is arguably the most common risk factor used in estimating expected stock returns. Despite of its popularity several past studies documented weak (if any) association between CAPMbeta and realized stock returns, which led several researchers to proclaim beta “dead”. This paper shows that the explanatory power of CAPMbeta is highly dependent on the way it is estimated. While the conventional beta proxy is indeed largely unrelated to realized stock returns (in fact the relationship is slightly negative), using forward looking beta and eliminating unrealistic assumptions about expected market returns turns it (highly) significant. In addition, this study shows that complementary empirical factors – size and ratio of book-to-market value of equity – that are sometimes presented as potential remedies to beta’s deficiencies do not seem to outperform beta. This suggests they are not good risk proxies on the Swedish stock market, which casts doubt on the universal applicability of the 3-factor model. Keywords: asset pricing, CAPM, beta, factor pricing models, 3-factor model, market efficiency,...

...obtain an estimate of its true beta coefficient; then we use the findings to estimate and plot the Security Market Line (SML). In doing so, we have two purpose to fulfill. First, demonstrating the fact that the total variance of a portfolio approaches the systematic variance as diversification increases, which means diversifying across industries offer benefit over diversifying within a given industry. Second, using the figures estimated to testify that the CAPM works in practice.
The capital asset pricing model (CAPM) provides us with an insight into the relationship between the risk of an asset and its expected return. This relationship serves two significant functions. First, it provides a benchmark rate of return for evaluating possible investments. Second, the model helps us to make an educated guess as to the expected return on asset that have not yet been traded in the marketplace. Although the CAPM is widely used because of the insight it offers, it does not fully withstand empirical tests. CAPM is a one-period model that treats a security’s beta as a constant, but beta can be changed in respond to firms investment in new industry, change in capital structure and so on. If betas change over time, simple historical estimates of beta are not likely to be accurate. Mismeasuring of betas will not reflect stocks’...

...10
Return and Risk: The Capital Asset Pricing Model (CAPM)
Multiple Choice Questions
I.
DEFINITIONS
PORTFOLIOS
a
1. A portfolio is:
a. a group of assets, such as stocks and bonds, held as a collective unit by an investor.
b. the expected return on a risky asset.
c. the expected return on a collection of risky assets.
d. the variance of returns for a risky asset.
e. the standard deviation of returns for a collection of risky assets.
Difficulty level: Easy
PORTFOLIO WEIGHTS
b
2. The percentage of a portfolio’s total value invested in a particular asset is called that asset’s:
a. portfolio return.
b. portfolio weight.
c. portfolio risk.
d. rate of return.
e. investment value.
Difficulty level: Easy
SYSTEMATIC RISK
c
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
a. idiosyncratic
b. diversifiable
c. systematic
d. asset-specific
e. total
Difficulty level: Easy
UNSYSTEMATIC RISK
d
4. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
e. total
Difficulty level: Easy
PRINCIPLE OF DIVERSIFICATION
10-1
e
5.
a.
b.
c.
d.
e.
The principle of diversification tells us that:
concentrating an investment in two or three large stocks will eliminate all of your...

...The Capital Asset Pricing Model (CAPM):
What Is It? How Does It Work? And Does It Work Effectively?
In 1960, a doctoral candidate in economics at the University of California, Los Angeles by the name of William F. Sharpe needed a dissertation topic. After reading a 1952 paper on portfolio theory by Harry Markowitz entitled Portfolio Selection, Sharpe had found his idea. Markowitz's paper presented the notion of an "efficient frontier" of optimal investment that advocated a diversified portfolio to reduce risk. However, his theory did not develop a practical means to assess how various holdings operate together, or correlate. Sharpe took Markowitz's theoretical work and greatly simplified it by connecting investment risk and reward to a single risk factor (beta) (Burton, 1998). With the publication of his 1963 dissertation A Simplified Model of Portfolio Analysis, Sharpe introduced the world to the Capital Asset Pricing Model (CAPM). Today, CAPM has become an integral part of investment theory and is used on a daily basis by investment practitioners and managers. The concept was deemed so important that in 1990, Sharpe was awarded the Nobel Prize in Economics for his contributions to the development of the CAPM theory. Since its introduction, there have been many questions concerning the relevance of the assumptions upon which the theory is based....

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