Write 7 pages thesis on the topic relative merits of the capital asset pricing model and empirical approaches to asset pricing.
Write 7 pages thesis on the topic relative merits of the capital asset pricing model and empirical approaches to asset pricing. The risk of General Electric’s is the contribution of General Electrics to the overall riskiness of the stock. The stock may be quiet risky when held on its own but its riskiness is mellowed down when it’s made a part of the overall portfolio. (Kothari, 1995) It determines the contribution of riskiness by individual stocks in a well-diversified portfolio. Not all stocks can contribute an equal amount of riskiness to a well-diversified portfolio. Different stocks will affect the portfolio differently, so the amount of their riskiness will vary. Therefore the relevant riskiness of a stock to its portfolio is called the beta-coefficient. In light of the CAPM terminology, it is a measure of the risk that the stock contributes to the total risk of the portfolio in general. According to the CAPM definition, the formula for Beta is as following:
This explains to us why stocks that have higher standard deviation will have a higher beta and those that have smaller standard deviation will have the smaller beta. It should also be noted that those stocks that have a higher correlation with the market will also have a higher beta.
The cost of capital is the minimum return which is needed by the financial markets to provide capital to the firm. In CAPM, the markets are assumed to be efficient. The returns, on the other hand, are expected to be conditional. This explains why the cost-of-capital is equated with the expected return when the Cash flows are discounted back for multi-period discounting formula. It becomes complicated to associate discounting rate to a multi-period discounting formula when conditional expected returns are variable with respect to time. The approach is slightly different when there is auto-correlated variation in the risk and the prices of risk. When there is auto-correlated variation in risks, then one period expected returns follow. The sum of expected cash flows discounted for one period are not equivalent to market value any more. However, despite this, concepts such as cost of capital and the present value concepts are used widely and more particularly when returns vary with time. .
