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Dear Professor,
Good morning, here are 3 confusing questions on CAPM model. Thank you for your response in advance.
Question 1:
Assume there are 2 shares and their performance in 2 cases. To be simple, share 2 is riskier than share 1 because its variation is more volatile in different cases.
SHARE 1
Case 1?-10%
Case 2?+10%
SHARE 2
Case 1?-50%
Case 2?+50%
In such a situation, the expected returns of 2 shares are both ZERO. But due to the CAPM model, the more risky share has a bigger beta, thus has a bigger return, which conflicts with the calculation ZERO. What is wrong with it?
Question 2:
In the theory of CAPM, there is a sentence:
“An efficient capital market does not reward people for bearing risk that rational investor would eliminate by diversification.” In my understanding, I could know that diversification could eliminate Unsystematic risk, leaving Systematic risk. So, no need to reward for the Unsystematic risk.
However, assume there are share 3 and share 4.
SHARE 3
Case 1 (50%)?-10%
Case 2 (50%)?+10%
SHARE 4
Case 1 (50%)?+50%
Case 2 (50%)?-50%
In order to remove the Unsystematic risk, a rational investor would buy FIVE share 3 and One share 4, so that in no matter case, he will gain nothing. Is he rational?
Question 3:
Further to Question 2, if an investor only buys share 4, obviously he bears the Unsystematic risk of share 4 (50% to loss). But he actually gets rewards (50% to win) instead of nothing. So bearing Unsystematic risk gets a reward. What is wrong with it?
Thank you so much for your time and patience.
1. The figures are not realistic, partly because there is never a situation where there are only 2 possible returns and the expected return would never be zero anyway. That is not how CAPM works. The returns will vary as the overall market return varies but the higher the beta the greater the variations in the required rate of the return.
2. I do not know where you read this. CAPM is explained in all the detail required for Paper FM in my free lectures. Unsystematic risk cannot possibly be removed from a portfolio of only two shares.
3. This is again completely hypothetical and bears no relation to the use of CAPM either in practice or (more importantly) in the exam.
I really do suggest that you watch my free lectures. They are a complete free course for Paper FM and cover everything needed to be able to pass the exam 🙂
Thank you sir.
Further to my Question 2, “An efficient capital market does not reward people for bearing risk that rational investor would eliminate by diversification.” so bearing unsystermatic risk, for example, buying one share in the market, could not get extra return.
Is it correct?It could in the short term, but not in the long term.
Have you watched my free lectures on CAPM?
Thank you Sir.
I have reviewed the lectures and here is a new question. I am sorry.The question is:
In the lecture “CAPM and MM Combined”, I could understand your teaching, but I feel weird about the formula.To be simple,
WACC=(E/V * ke) + [D/V * kd * (1 – Tc)], WACC is the comprehensive cost including the ke and kd, that is, considering the gearing effect.However, in the ungeared beta,
beta of asset = proportion1 * beta e + proportion2 * beta d, ( beta d = 0 usually)
why the beta of asset does not include the gearing effect?Thank you for your reply in advance.
It makes no sense to watch lectures at random – they are a complete free course.
The WACC is the overall cost of capital to the company and therefore automatically includes the cost of any debt borrowing. It is not always calculated using the formula you quote (for reasons that I explain in my lectures on the cost of capital). It is the rate we use to appraise new capital investments.
What you have written with regard to the asset beta is not true. The ‘formula’ you quote is only relevant when two (or more) streams with differing betas are combined.
The asset beta measures the risk of the business. The equity beta measures the risk of the shares, and shares are more risky if there is any gearing if the company. When using the asset beta formula in the exam we always assume the debt beta to be zero (in practice it will not be zero, but will obviously be small).
Again, there is no point in just watching lectures at random. You need to watch all of the lectures on the cost of capital to make sense of it, and you cannot expect me to type out all my lectures here 🙂
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