Capital Asset Pricing Model (CAPM): Definition, Formula & Example

Question 1 

Capital Asset Pricing Model (CAPM) is a model that helps to calculate the expected returns on investment under different risks experienced in the market. The model has an integral role in the process of analyzing capital assets. The alternative to the CAPM model is the Arbitrage Pricing Theory (APT), which is an asset pricing model that focuses on the idea of an asset's return. The recommendation of APT as the most appropriate alternative to CAPM is based on the fact that it focuses more on the risk factors rather than the assets (Carassus & Rásonyi, 2020). The second significant reason for the selection of the recommendation of the alternative is that APT is denser and focuses more on creating a description of the expected returns. The description of the expected returns takes place in a linear function of the risks experienced. Additionally, it is important to note that APT requires users to quantify the multiple factors that are present in the model. The ATP can be regarded as an appropriate alternate considering that it requires fewer assumptions compared to those required in the CAPM model.

Question 2 

The multifactor models have a significant role in portfolio analysis and are an essential aspect of the investors. The first significant role of the models is to enable the investors to consider different risks that have a major impact on the investment portfolios. The risks may include a wide range of factors that relates to microeconomics and macroeconomics (Carassus & Rásonyi, 2020). The multifactor models allow investors to engage in an effective process of determining the risks that may be included in an evaluation. To improve the understanding of the investors on matters concerning the multifactor model, it is important to focus on the illustration of the risk factors that helps to identify the cross-correlation and de-risking factors relating to different investments. The ability to improve on the understanding of the investors is an important aspect that helps to promote the quality of operations undertaken within a business environment. The recommendation to the investors may help in ensuring that they understand the need to implement the multifactor models to determine risks and impact that may be experienced in investment.

Week 5: Business Risk and Analysis 

Question 1 

Business risk refers to the uncertainty of the operating income that is experienced in a company resulting from factors within the industry. In the analysis of business risk in a steel company and a retail food chain, I believe that a steel company may have a greater business risk. Firstly, the general overhead costs that are required to operate a steel business is relatively higher than the cost required to operate a retail food chain. That means that it is difficult for the steel business to turn in profits. The second important aspect of consideration is the level of convenience of the products in each of the given businesses. According to Rahayu (2020), the level of business risk can be assessed by the level of convenience of the products. The retail food chains tend to be more convenient in terms of location and the necessity of the products. In that case, it is easy for the business to gain a higher number of customers compared to the steel company, which does not comprise of convenient products. Lastly, the unstable demand for products within the steel company is a factor that increases the business risk level compared to the demand for products provided within the retail food chain.

Question 2 

In any economy, industries have different relationship trends, which is an aspect that results from the demand and supply of products offered. The variation of demand and supply of products in the industries depends on factors such as location, needs, and economic class. The law of supply and demand is the main reason why it is not possible to expect a similar relationship trend in all industries. The law of supply and demand has a vital role in defining the opportunities presented for different companies and the trends experienced (Rahayu, 2020). An example of two industries that have a different relationship in the economy includes Apple and IBM. The two companies are established firms that engage in the provision of different products and services. The difference between the companies is that each capitalizes on the implementation of different strategies to attract customers and become relevant in the industry. However, it is necessary to note that both companies engage in the implementation of measures to adapt to constant changes and trends that are necessary to meet the demands of the customers.

Week 6: The Anomaly of Value Growth 

Question 1 

The first possible explanation of why value stocks might outperform growth stocks is that growth investors capitalize on the current and future history of a company without focusing on the aspect of share valuation. On the contrary, the interest of a value investor is on the anticipation of a market correction. The value investors enhance the process through share price and the effort to improve on the fundamentals of a company. Although the difference between value and growth investing is straight forward focusing on the theoretical aspects, it is necessary to note the fact that the majority of analysts in an economy rely more on the obtained financial indicators (Clare et al., 2019). Some of the key financial indicators include P/B ratios, EPS growth rates, and dividend yields. The financial indicators have an integral role in defining the style benchmark portfolios and individual equity. Additionally, the classification of different firms according to factors such as market capitalization is an important aspect that helps towards understanding the differences in value stocks and growth stock.

References

Carassus, L., & Rásonyi, M. (2020). Risk-Neutral Pricing for Arbitrage Pricing Theory.  Journal of Optimization Theory and Applications , 1-16.

Clare, A., Seaton, J., Smith, P. N., & Thomas, S. (2019). When Growth Beats Value: Applying Momentum Filters to Growth and Value Portfolios.  The Journal of Investing ,  28 (5), 69-84.

Rahayu, S. M. (2020). The Role of Moderation in Fund Structure on the Impact of Liquidity, Business Risk, and Resource Use Activities on Company Value as a Variable That Influences Company Values.  Journal of Critical Reviews ,  7 (13), 863-872.