Capital Asset Pricing Model Essays - Mathematical Finance, Beta

Capital Asset Pricing Model The theory of the Capital Asset Pricing Model - CAPM is pretty basic. This theory though it seems very small is a very important part of the business world. The expected return on a long futures position depends on the Beta of that individual futures contract. If the Beta is greater than 0, the futures price should rise over time. If the Beta is equal to 0, the futures price should remain the same over time. If the Beta is less than 0, the futures price should decline over time. The Capital Asset Pricing Model - CAPM shows risk in a particular asset. With the Capital Asset Pricing Model - CAPM, traders can avoid much of the risk they receive because this broadens their chances. Therefore, only unavoidable risk should or will be compensated. Nevertheless, even after a trader expands his portfolio, some risk will remain. Because some risk is associated with the market as a whole, this risk cannot be countered through expanding. In other words, no matter how hard a trader tries to avoid risk, some risk will remain. This is just a fact of a matter and will not and cannot be changed. DeNarius Thomas Business Finance October 30, 2000 Beta Coefficient The Beta measures the risk associated with one particular asset in relation to the overall market. Beta also measures how much a stock tends to change in price relative to the market as a whole, based on the last 60 months of market. Therefore, with a Beta of zero, the return should be zero. A Beta above zero should bring a positive return to a long position. And a Beta below zero should bring a negative return on a long position. For example, a beta coefficient of one would mean that the market and the given stock tend to move the same. So, a five percent move in the market should produce a five percent move in the stock. A beta coefficient of two will fluctuate twice as much as the market. Beta is used is used in many different modes. One of the modes is low relative mode. This is used to find stocks that fluctuate less than the market. But, if you think that the market is moving up and down and you want to find stocks that will move up faster than the market, you would use the high relative mode. Absolute mode is another mode used by Beta. This mode is used when you want to find stocks that move. If the stocks are faster than the market you use 1.5 as the minimum and 10 as the maximum. If they are slower than the market than you would use 0 as the minimum and .50 as the maximum. DeNarius Thomas Business Finance October 30, 2000 Market Risk and Diversifiable Risk Market Risk descends from market-wide factors and these factors affect all businesses and the economy as whole. These factors include things such as interest rates, inflation rates, currency exchange rates, unemployment rates. Not only are these factors but another factor is the risk of natural disasters such as earthquakes, floods, fire, etc. It is generally not possible to diversify away from this risk. The only possible exception to this statement is where an investor chooses to reposition from a domestic market to an international market. Risks previously thought of as Market Risks may now become Specific Risks. For example, a Japanese investor who only operates on the Tokyo markets may think of Market Risks in a Japanese context. By moving to world markets, some risks, previously thought of as Market Risks now become Specific Risks, in other words specific to the Japanese markets and, therefore becomes diversifiable. The difference in Market risk and Specific risk (diversifiable risk) is that Specific risk only affects specific businesses not general ones as Market risk does. Specific risks apply to an individual company, a company with a particular industrial sector, and companies in a specific geographical of country region. They can be managed by using the Modern Portfolio Theory. This tells us that by combining assets whose returns are not associated with one another, we can determine combinations of assets that provide the least risk for each possible expected return.