CAPM Assignment Example | Topics and Well Written Essays - 1000 words - 3

CAPM - Assignment Example An investment of risky investment calls for compensation of the respective investor for the time and money devoted to the investment. Typically, the time value of money is symbolized by risk free (rf) in the formula. This is meant to reimburse an investor for investing money for some period of time. On the other hand, the risk measures the amount of reparation that is needed by an investor for taking an additional risk. It is computed by taking the beta that measures the return of the asset in the market over a period and market premium. Other assumptions of the model are: there is perfect competition in the market and, therefore, an individual cannot affect any price of an asset by selling or buying. All the investors have the same information regarding the availability of the securities prices and their respective risks involved. All investors in the market have an idea of making decisions based on variances and expected returns of the portfolios they desire to invest. It should be noted that beta indeed measures the amount of risk that is involved in investing in a particular stock in relation to the market risk. For example, if the market beta is 1 and an investor’s security has a beta of 2, it would be riskier than an investor’s security of 0.25. The theory postulate that expected return of a portfolio is equal to risk free security plus a risk premium then multiplied by systematic risk of the asset. Ra = rf + Beta (rm –rf). For example in the market, the risk free rate =4%, the beta of the stock = 2 and market return is 12% over time, the expected return of the stock will be 4%+2(12%-4%) =20%. The beta, therefore, provides an answer to the risk return relationship. CAPM model provides a vital account for pricing the debt and equity. This is because it takes into consideration factors like risk free rate that is