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Hi Karen,
IT IS THE SYSTEMATIC BUSINESS RISK + THE SYSTEMATIC FINANCIAL RISK WHICH CAN NOT BE DIVERSIFIED AWAY.
Some key points to help you with this:
WELL DIVERSIFIED PORTFOLIOS
CAPM assumes all INDIVIDUAL INVESTORS hold well diversified portfolios.
CAPM assumes all UNSYSTEMATIC BUSINESS risk has been diversified away, or eliminated.
Therefore, CAPM assumes that the Total Risk (BETA) of a share, investment, project, company = SYSTEMATIC Business + SYSTEMATIC Financial Risk.
According to Portfolio Theory “Total Risk = Unsystematic Risk + Systematic Risk”
According to M&M “Total Risk = Business Risk + Financial Risk”
CAPM says that Beta measures the relative Systematic Business Risk + Systematic Financial Risk … of the Project, Investment, Share, Company, etc., under consideration.
Regards, Kevin
Thank you that has put my reading into some sense – the more I read of M&M the more confused I get with some of their theories, such as dividend policy and the effect on share price? Are all M&M theories based in an ideal world with ideal markets?
What is your view on the risk free rate of return? Is this not based on goverment %’s that will never happen in reality?
Rm = Return required by the market – so we have a return required by the market x the risk factor (Beta). I am not really getting the Rf, we subtract from the Rm to get the Premium but add it on again – what is the reason for that?- Topics: 1
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Karen, you are not correct in what you are stating here … you need to look more closely at the model and you will see that the risk premium is ADDED to the risk free rate (Rf)
CAPM states that Ke =>
RA = Rf + B(Rm – Rf)
Regards, kevin
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