1. Please discuss and explain the CAPM and the SML. Provide a numerical example for the CAPM. Total risk is the relevant measure of risk, do you agree?
The security market line (SML) is a line that charts the efficient, or market, risk versus return of the entire market at a specific time and demonstrates all risky marketable securities. The SML basically diagrams the outcomes from the capital asset pricing model (CAPM) recipe. The x-hub speaks to the risk (beta), and the y-hub speaks to the normal return. The market risk premium is resolved from the incline of the SML.
The capital asset pricing model (CAPM) is a model that depicts the relationship amongst risk and expected return and that is utilized as a part of the pricing of risky securities.
…show more content…
How is beta, from the CAPM, estimated?
Beta is the measure of a stock 's affectability of profits to changes in the business sector. It is a measure of efficient risk. Beta is a critical measure that is utilized as a key contribution for Discounted Cash Flow or DCF valuations.
Recipe for Beta:
Beta = B = Covariance of stock to the business sector/Variance of the business sector
• If Beta = 1: If Beta of the stock is one, then it has the same level of risk as the stock business sector. Henceforth, if stock business sector (NASDAQ, NYSE and so forth) ascends by 1%, the stock cost will likewise climb by 1%. On the off chance that the stock business sector moves around 1%, the stock cost will likewise move around 1%.
• If Beta > 1: If the Beta of the stock is more prominent than one, then it infers larger amount of risk and unpredictability when contrasted with the stock business sector. In spite of the fact that the bearing of the stock value change will be same, in any case, the stock value developments will be somewhat extremes.
• If Beta >0 and Betas prosperity.
Example of Unsystematic Risk that may be particular to individual organizations or commercial ventures are business risk, financing risk, credit risk, item risk, lawful risk, liquidity risk, political risk, operational risk, and so forth. Unsystematic risks are viewed as manageable by the organization or
By focusing on only one risk, for example peer risk, it leaves the company up for even more risk in its assets and pension obligations. Figure 1 illustrates that these risks do indeed rely on one another. When investors try to only minimize one of the risks (small circles) stockholders leave themselves open / exposed to the other two scopes of risk: Beta and Matching (ALM).
The Smith & Wesson Holding Corporation stock has an EPS of 1.42 and a P/E ratio of 10.52. Upon running a regression, a coefficient of 0.139 was calculated. This means that if the SWHC stock increases by 1%, the S&P 500 stock will increase by 0.139%.When compared against the S&P 500 index, the SWHC stock has a correlation of 16.3%. This is relatively low. The SWHC stock can explain approximately 16.3% of the variation in the S&P 500. In other words, the stock does not behave the same as the S&P 500 and should not be used to predict the S&P 500. There is about 83.7% of the...
For example if ABC Goods had 1 million shares and they all cost R10 their market cap would cost R10million that is basically the cost of the company and how much you can offer to buy the company and the shareholders should be okay with it and it can also refer to the total amount of the stock exchange
α is the intercept of the regression line, and β is the slope of the regression line. e is the random disturbance term. The equation Y = α + βX (ignoring the disturbance term “e”) gives the average relationship between the values of Y and X.
After finding the appropriate risk-free rates and risk premiums, we began finding the Betas for each division of Marriott (Exhibit 1). We began by selecting an appropriate proxy firm for each of Marriott's three divisions. Lodging was the first division we analyzed. La Quinta Motor Inns seem to be the best pure-play. La Quinta's operations consisted of strictily lodging. It owns, operates, and licences motor inns which matches well with Marriott's operations in the lodging division. In order to calculate the betas of this division, we had to find the cost of debt. The cost of debt we used came from interest rates on long-term 30-yr government bonds plus it's debt rate premium because Marriot's lodging assets had long-term useful lives. After finding the cost of debt for the logding division, we calculated the division's beta of debt which came out to be 1.0233. Finally, we used the beta of debt to find the beta of the division's assets which came to .737.
Fama and French findings shocked the modern portfolio theory and their study was nick named "Beta is Dead". With respect to CAPM they found that stocks with high betas did not have consistently higher returns than low-beta stocks. Furthermore, Fama and French concluded that a high book value to market value was the most important variable related to predicting high stock returns on small cap stocks. These findings were published in a 1992 paper titled "The Cross-Section of Expected Stock Returns".
My estimate of Nike's cost of equity is 10.5%. I used the current yield on 20-year Treasury bonds as my risk-free rate, and the compound average premium of the market over Treasury bonds (5.9%) as my risk premium. For beta, I took the average of Nike's betas from 1996 to the present.
However, both have the different to the definition of risk. Sharpe ratio use the standard deviation to defined the risk of volatility however treynor ratio is used Beta as a measure of market systemic risk (nobeltrading, 2010). Treynor ratio is useful for determining how it is useful to help diversify portfolio. Treynor measurement or reward to volatility ratio is a factor of fund performance adjustment based on the systemic risk of the fund's income, reflecting the excess returns from the fund's unit system risk. It is used to calculate the investment performance per unit risk (Wathen, 2015).
Equity capital represents money put up and owned by shareholders. This money can be used to fund projects and other opportunities under the auspice of creating greater value. This type of capital is typically the most expensive. In order to attract investors, the firms expected returns must consummate with the associated risk ("Financial leverage and,"). To illustrate this, consider a speculative oil drilling operation, this type of operation would require higher promised returns than say a Wal-Mart in order to attract investors. The two primary forms of equity capital are 1) money invested into the business for an ownership stake (i.e. stock) and 2) retained earnings from past profits used to fund future growth through acquisitions, expansions and product development.
These risks will have material effect on the organisation 's ability to sustain its business and operational goals and objectives.
Primarily, financial managers look at the market price in maximizing the value of the firm. The market value is the present value of the net cash flow divided buy the risk. Investors consider the firm’s future and present earnings, disadvantages or risks and other factors that will influence a firm prior to deciding to create an investment decision and the market price of the stock that will reflect all the information considering these factors (Arain, 2011).
The final model used to compute the cost of capital was the earning capitalization model. The problem with this model is that it does not take into consideration the growth of the company. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way:
Identify the potential risks which affect the company and manage these risks within its risk appetite;
Operational risks are risks that may occur in the day to day activities, which may involve the process, systems, or people. Strategic risks are those risks involved with strategy. Positioning ones’ company with the right alliances and competing with fare prices will help affect future operational decisions. Compliance risks involve the many legislations and regulations a company must follow. The results could lead to high penalties and a company’s reputation could take a hit. Lastly, financial risks are always being monitored because oil, fuel, and currency rates are constantly fluctuating. By monitoring the fluctuating rates determines fare cost and balancing of the budget. “Like in any other industry, the risk exposure quantifies the amount of loss that might occur from any particular activity” (Genovese,
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.