Capital asset 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 Portfolio
We all know that investments have risk, so it’s safe to assume that all stocks have risk as well? But did you know that there are different types of risk as well? Most people think that all risk is the same but it’s true. There are some risk that you can avoid via diversification and other types of risk that are 100% completely unavoidable meaning you can’t dodge it or rid of it it’s always there. The risk of a portfolio comprises systematic risk, also known as undiversifiable risk and Unsystematic risk is also known as idiosyncratic risk or diversifiable risk.
Systematic risk that is unavoidable. It refers to the risk common to all securities—i.e. market risk. Systematic risk is due to risk factors that affect the entire...
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