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CAPM, EMH, and Risk Aversion

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a. The Capital Asset Pricing Model (CAPM) is a widely used concept in finance. The Model is
expressed graphically by the Security Market Line (SML). Within the context of investment,
explain how CAPM can be useful to investors.
b. Explain Efficient Market Hypothesis (EMH) and the different types of market efficiency.
Do stock market anomalies contradict the concept of market efficiency? Explain.
c. The distributions of rates of return for Security AA and Security BB are given below:

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Solution Summary

The questions on CAPM, EMH and rates of returns are answered in 542 words, including calculations where appropriate.

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a. CAPM is a model that prices securities by considering the risk level of the security and its expected rate of return. CAPM incorporates the concept that investors need to take into account both the time value of money and the risk level of the security when deciding whether to invest in the security. If the expected return calculated using CAPM is less than the desired return, then the investor should not purchase the security. In this way, an investor can use CAPM to decide whether to invest in a security.

b. EMH is a theory used in investments that states stock prices always incorporate and reflect all relevant information pertaining to the stock. In other words, EMH states that stocks will ultimately trade at their fair value on stock exchanges. A result of EMH is that it is impossible for investors to beat the market ...

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  • MSc, California State Polytechnic University, Pomona
  • MBA, University of California, Riverside
  • BSc, California State Polytechnic University, Pomona
  • BSc, California State Polytechnic University, Pomona
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