The Capital Asset Pricing Model



Abstract

Capital Asset Pricing Model (CAPM) has been of great importance to investors and organizations. It helps to calculate the expected return according to the level of risk involved in a particular investment. The paper aims at identifying the importance of CAPM to investors and organizations. It also differentiates between diversifiable and un-diversifiable risks with examples and shows the calculations of CAPM model.

Contents

Diversifiable Versus Un-Diversifiable Risk1

Substantial Unexpected Increase in Inflation1

Major Recession in US1

Major Lawsuit against One Large Publicly Traded Corporation1

Calculation of CAPM2

CAPM to corporations and to investors3

References4

The Capital Asset Pricing Model

Diversifiable Versus Un-Diversifiable Risk

Substantial Unexpected Increase in Inflation

The unexpected rise in inflation occurs on those assets that provided returns in the past. Inflation risk is defined as the risk of unexpected price increase. It is an un-diversifiable risk for an investor because no matter how diversified the portfolio is, an investor can never account for inflation. It is applicable on all the stocks and commodities alike. The extremely diversified portfolios including natural resources, commodity futures and Treasury Inflation-Protected Securities (TIPS) are a way to protect an investor from the risk of inflation (Bhardwaj et al., 2011)

Major Recession in US

Recession in US is un-diversifiable risk for an investor because an investor has no control on the macro environment of the state. An investor cannot mitigate this risk by diversifying because it affects the overall markets and not just one company's stock. The recession is a hit on one particular country or region, so investing in foreign assets can help the investor to diversify his investment (Bullard et al., 2009)

Major Lawsuit against One Large Publicly Traded Corporation

Major lawsuit against a large publicly traded corporation is diversifiable risk because the risk is associated with one company only. Every organization has some level of risk and the investor can mitigate ...