Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Consider the three factor APT model
Factor Risk Premium
Change in GNP 5%
Change in energy prices -1
Change in long-term interest rates +2
Calculate the expected
a. A stock whose return is uncorrelated with all three factors
b. A stock with average exposure to each factor (i.e., with b = 1 for each)
c. A pure play energy stock with high exposure to the energy factor (b=2) but zero exposure to the other two factors
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