Category Archives: RISK AND RETURN

Under- and Over-valued Assets:

Under- and Over-valued Assets: If individual assets and portfolios are priced correctly, they lie exactly on the SML. Assets plotting off the SMI, indicate misprinting of assets by the market, Assets that plot above the SML are undervalued. They offer higher expected return than assets of a similar risk class. Hence, they are attractive. The buying pressure for such assets will. push up their price and lower the

Unlevering and Relevering Beta

Unlevering and Relevering  Beta It may be recalled that the beta of a portfolio formed by combining two assets is the weighted average of their betas. If we view all the assets of a firm as a portfolio of debt and equation, (the two sides of the balance sheet of the firm), the market value of the firm (V) equals the asset value as well as the sum total of the market values of debt (D) and equity (E). Therefore


Beta It measures the risk (volatility) of individual to till market portfolio. According to the return with the market portfolio’s return, divided by the market portfolio (13 = 0). The co-variance of two assets, he product oil their correlation standard deviations. The co-variance of the market portfolio with itself is the variance of the portfolio. Thus, the assets of the market portfolio be one. This i

Risk-Premium on Market Portfolio

Risk-Premium on Market Portfolio Market risk premium or the risk premium on market portfolio is the difference between the expected return on the market portfolio and the risk-free rate of return. The CAPM holds that in equilibrium, the market portfolio is the unanimously desirable risky portfolio, It contains all securities in exactly the same proportion in which they are supplied, that is, each security is he

Risk-Free Rate

Risk-Free Rate The rate of return available on assets like T-bills, money market funds or bank deposits is taken as the proxy for risk-free rate. That is maturity period of T-balls and bank deposits is taken to be less than one year, usually 364 days. Such assets have very low or virtually negligible default risk and interest rate risk. However, under inflationary conditions, they are risk-less in nominal terms

Risk-return Relationship

Risk-return Relationship In the CAPM, the expected return on an asset varies directly with its systematic risk and the risk premium of the market portfolio, In other words, the risk premium for in asset or portfolio is a function of its beta. The risk premium added to the risk-free rate is directly proportional to beta. The risk premium of a market portfolio, also referred to as reward, depends on the level of

Security Market Line (SML)

Security Market Line (SML) .We know that risk averse investors seek risk premium to assume the risk embedded in risky assets. The risk is variability in return. The total risk consists of two components: systematic risk and unsystematic risk. In a portfolio of risky assets, the investor can eliminate unsystematic risk through diversification, as suggested by Markowitz. Systematic risk is unavoidable; this is th

Elements of the Model

Elements of the Model The capital asset pricing model consists of two elements: the capital market line (CML) and the security market line (SML).The capital market line, as discussed before, represents the efficient frontier formed by combining one-month T-bills with a broad index of common stocks. Its serves to functions. First, it depicts. the risk-return relationship for efficient portfolios available to inves


Assumptions To grapple with the complexities of the real world, the CAPM makes certain simplifying assumptions. Since of these may be relaxed later. 1. All Investors arc price-takers: Their number is so large that no single investor can affect prices. 2. All investors use the mean-variance portfolio selection model. of Markowitz. 3. Assets/securities are perfectly divisible. 4. All investors plan for one identica


CAPITAL ASSET PRICING  MODEL (CAPM) The capital asset pricing model (CAPM),as the name suggests, is a theory that explains how asset prices are form~ in the market place. II is a logical and major extension of the portfolio theory of Markowitz by William Sharpe (964),9 John Lintner (1964)0 and Jan Mossin (1967)11. The capital asset pricing model provides the framework for determining the equilibrium expired ret