Financial institution Essay Example | Topics and Well Written Essays - 2750 words

Financial institution - Essay Example The remaining part represents the ‘risk premium’ where the market return earned in excess of the risk free rate is multiplied with the ‘beta’ of the stock. It is essentially the return for bearing additional risk (Investopedia, 2010). If the expected rate of return on a security is more than the required rate of return then the investment in profitable whereas if the expected return is less than the required rate of return then the investment is not profitable. Unlike Mean Variance Portfolio theory the CAPM model rewards for the excess beta or additional risk borne by the investor. Higher the beta higher is the compensation required by the security. As per this model a higher ‘standard deviation’ does not mean a higher return as ‘beta’ is the measure of risk under CAPM and not ‘standard deviation’. In the CAPM world an investor is rewarded for bearing the risk that cannot be diversified. This is referred as ‘syste matic risk’ captured by the beta of the stock. An investor is not awarded for bearing any nondiversifiable risk i.e. unsystematic risk captured by the standard deviation of the stock. In other words the investors are rewarded for bearing the risk that cannot be diversified away. This is also referred as ‘market risk’ (Sigman, 2005). Assumptions under CAPM- The first assumption under this model is that the transaction costs do not exist. This means that the purchase or sale of an asset does not require any cost. The second assumption is that the CAPM model assumes all assets to be infinitely divisible. This implies that an investor can take a position in the market irrespective of their wealth position. There exists no ‘personal income tax’. This implies that an investor is not influenced by the nature of gain whether it is in the form of capital gain or dividend. There exists perfect competition. This means that a person cannot influence the stock pr ice by going long or short in it. The investors base their investment decisions on the standard deviations of returns and expected value on their investment portfolio. There is no limit on short selling. CAPM also assumes that there is unlimited lending and investing at the risk free rate. CAPM assumes homogeneous market expectations. The last assumption is marketability of all assets (Elton, et al., 2009, p.283). Beta Co-efficient The beta is the sensitivity of stock return to the market return. Higher the beta higher is the risk associated with the stock. Gitman (2006) states that beta is â€Å"a measure of non-diversifiable risk† i.e. it measures the return on asset with reference to the market return. Ideally the beta of a stock should be â€Å"forward-looking† and measured with respect to the whole market, whereas in practice this is based on historical returns and the stock index acts as a proxy for ‘market return’ (Kurschner, 2008, p. 3). Suppose th e beta of Stock A is 2. In the event of a 10% rise or fall in the market the price of Stock A will rise or fall by 20% respectively. Stocks with a beta of more than one are referred as ‘aggressive stock’ and stocks with a beta of less than one are referred as ‘defensive stock’. One can invest in aggressive stocks in times of market upswings and such stocks must be avoided in times of uncertain market conditions. In short the beta co-efficient of a stock measures the volatility in the return of a stock with respect to the market benchmark. Criticism of CAPM The assumptions of CAPM