BEC - 3

Question 1

CAPM formula

Answer 1

RR = RFR + beta (ERR - RFR)

RR: required rate of return
RFR: risk-free rate of return
Beta: measures volatility of asset
ERR = Expected Rate of Retrun)

Question 2

Beta (2 definitions)

Answer 2

1. measure of systematic risk as reflected by the volatility of an investment or other asset
2. measure of volatility of an asset when compared to a benchmark for the whole class of that asset

Question 3

What are the 3 states of beta?

Answer 3

1. Beta = 1; asset being valued moves in line with benchmark
2. Beta > 1; asset being valued moves greater than benchmark (asset is more volatile)
3. Beta

Question 4

Name 3 uses of CAPM

Answer 4

1. Securities analysis
2. Capital budgeting
3. Setting fair compensation for regulated monopolies

Question 5

CAPM Assumptions & Limitations

Answer 5

• There is an asset class and benchmark for the asset being valued
• All investors have equal access to all investments of the class being valued and all use a one-period time horizon
• Asset risk is measured solely by variance of the asset being valued from asset class benchmark
• No external costs involved - no commissions, taxes, etc.
• No restrictions on borrowing or lending at the risk-free rate; all parties can do so
* Uses historical data, which may not be appropriate for computing future returns

Question 6

A graph that plots beta would show the relationship between

Answer 6

Asset return and benchmark return for the class

Question 7

Diversifiable risk

Answer 7

Unsystematic or firm-specific risk CAN be eliminated through diversification

Question 8

Non-divdersifiable risk

Answer 8

Systematic or Market-related risk canNOT be eliminated through diversification

Question 9

General business risk is measured by the expected variability in

Answer 9

EBIT

The greater the variability in EBIT, the greater the perceived business risk

Question 10

Inflationary risk

Answer 10

Purchasing power risk that a rise in general price levels will result in a reduction in purchasing power