CHAPTER 2: PART III: CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) relates the expected return on an asset to its systematic risk. The relationship is known as the Security Market Line (SML). The measure of systematic risk in the CAPM is refered to Beta.

An asset's total risk = systematic risk + unsystematic risk
....Systematic risk (market risk/undiversifiable risk) is the portion of an asset's risk that cannot be eliminated even using diversification. Its refer as Beta
.....Unsystematic risk (firm-specific/diversifiable risk) is the portion of an asset's total risk that can be eliminated via diversified portfolio.

BETA ASSET AND BETA PORTFOLIO
Beta (β) of a stock or portfolio refer to the degree of tendency on return or risk as compared to return/risk of the financial market as a whole.
               IF;    Beta asset or portfolio = 0; returns/risks of the asset or portfolio change independently 
                                                                               of changes in the market's returns/risk.
                             Beta asset or portfolio POSITIVE = The asset's/portfolios' returns/risks generally follow
                                                                                      the market's returns.
                             Beta asset or portfolio NEGATIVE = The asset's/portfolios' returns/risk generally move
                                                                                     opposite the market's returns/risk.

Assume that,

By using CAPM; the ERR(RRR) for stock Sykt. 1, Sykt.2 and Sykt.3 are:-

                                    Sykt. 1: ERR(RRR) = 5% + (10%-5%)0.85 = 9.25%
                                    Sykt. 2: ERR(RRR) = 5% + (10%-5%)0.7   = 8.50%
                                    Sykt. 3: ERR(RRR) = 5% + (10%-5%)1.5   = 12.50%

                   Beta Portfolio = sumWiBi
                                         = 0.2(0.85) + 0.4(0.7) + 0.4(1.5) = 1.05
                                            (which means, the portfolio returnd/risks generally follow the market returns/risks)

Refer to P4122 Learning Kit Tool for further explaination on CAPM; Supposed students should know how to plot SML and make decision on the acceptance and rejected area.

Thank you.