Enter queAnalysis of a financial model used in decision-making implies a thoroug

Question

Enter queAnalysis of a financial model used in decision-making implies a thorough understanding of what it can and cannot reveal about financial data. Managers need to understand the strengths and limitations of a financial metric, in order to employ it effectively. Before class Day 3, explain how the Capital Asset Pricing Model (CAPM) works. What are the strengths and weaknesses of the CAPM? (You may need to review Chapter 8 in Fundamentals of Financial Management to fully answer this question.) Using each of the four stocks you selected for your portfolio in the Week 4 discussions, calculate the Security Market Line (SML) equation for each stock. Assume a U.S. Treasury rate of 3% as the risk free rate in your SML. Use the beta for your stock as presented in http://finance.yahoo.com/. What does the SML tell you about your portfolio of stocks? How can the SML assist in predicting the expected return on your stocks? Below are my chosen 4 stocks I picked DELL, AAPL, GOOG and YHOO. From Yahoo Finance, we find that the betas are DELL = 1.39, AAPL = 1.04, GOOG = 1.13, YHOO = 0.94

Explanation / Answer

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (ß) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities—i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US will render the portfolio sufficiently diversified such that risk exposure is limited to systematic risk only. In developing markets a larger number is required, due to the higher asset volatilities. A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context—i.e. its contribution to overall portfolio riskiness—as opposed to its "stand alone risk." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. A value of beta in excess of 1 indicates a stock that has, historically, amplified the return of the whole market (positive or negative). A beta close to zero would indicate a stock that provided a more stable return than the market as a whole. A negative beta would signify a stock whose performance was counter cyclical, offsetting the overall market experience. DELL = 1.39, AAPL = 1.04, GOOG = 1.13-- GREATER RETURN THAN STOCK MARKET SINCE BETA > 1 YHOO = 0.94 -- ALMOST SAME RETURN AS STOCK MARKET

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