Chapter 4, Problem 4.1C

To determine

Introduction: Expected return on the security would be the sum of risk free rates and the risk premium considering the risk factor. Expected return for any asset including security can be computed by using return generating models such as APT and CAPM.

To discuss: Capital Asset Pricing model using systematic & unsystematic risk, beta, relationship between risk & return and relationship of beta with respect to price of stock.

Explanation of Solution

According to the CAPM model, there lies a relationship between risk and expected return from the portfolio or securities investment. CAPM is an abbreviation for Capital Asset Pricing model.

There are two types of risk involve in an investment namely systematic risk and unsystematic risk. Systematic risk is also represented as beta in CAPM model which refers to the risk that can be reduced by diversification whereas unsystematic risk is the risk that cannot be diversified or reduced.

The relationship between risk and return is directly proportional. As the risk increases the expected return also increases. The CAPM models can be expressed as follows:

  $\text{Expected return}={\text{R}}_f+\beta \left({\text{R}}_m-{\text{R}}_f\right)$

The systematic risk can be avoided through diversification that is by combining less number highly risky securities with some of the less risky securities. It is difficult to avoid unsystematic risk.

The stock prices in the stock market changes according to the value of beta. If the beta value is 1 then it is said to be a perfect relation with stock market. If beta is greater than 1 then the change in stock price is greater than the change in stock market whereas if the beta is less than 1 then the change in stock prises will be smaller as compared to the market.