Would you ever use CAPM to make personal investment decisions?
Note: the main message of the CAPM is the notion of diversification of investments. At least theoretically investors should only invest in two portfolios: one is the Market Portfolio (such as the S&P500 Index) and the other is a portfolio of short term or money market default-free securities.
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According to Investopedia.com, the Capital Asset Pricing Model (CAPM) "describes the relationship between risk and expected return and... is used in the pricing of risky securities." (Investopedia.com, 2007) The formula used for CAPM is shown below:
Ke= Rf +b(Km-Rf)
Ke= Cost of Equity
Rf= rate of return required on a risk free asset/ security/investment
Km= the required rate of return on the market portfolio
B= beta coefficient.
(Block & Hirt, 2005)
The CAPM prices individual securities or portfolios to determine expected return, and ...
Finance Problem Set: IPO in current economy, Determine Discount Rates, and CAPM for Personal Decisions
1. Given the current state of the economy, do you think right now would be a good time to take a company public? What would be the advantages and disadvantages of going through the IPO process at this time as opposed to waiting a year or two?
2. Discount rates will vary based upon your own personal level of risk tolerance. For example, I might be willing to buy a risky stock if I think I'll earn 10% while my wife would need at least 20% before she'd consider it. What's your discount rate for the following types of equities? How did you determine that rate?
a) A risk free equity (a US Treasury Note - called risk free because if they can't pay, your money is worthless!)
b) A CD at a South American bank paying in their local currency.
c) A stock in a company that has a secure stream of income from a long term contract customer.
d) A stock in a company that has an interesting business plan but no real operations as of yet (as NY Lotto says "A Dollar and A Dream")
And in addition, how would the recent huge fluctuations in the stock market affect your original response to the initial part of this question .
3. Would you ever use Capital Asset Pricing Model (CAPM) to make personal investment decisions? Why or why not?
Note: the main message of the CAPM is the notion of diversification of investments. At least theoretically investors should only invest in two portfolios: one is the Market Portfolio (such as the S&P500 Index) and the other is a portfolio of short term or money market default-free securities.View Full Posting Details