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CAPM - Health Care Finance

CAPM is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities (http://www.investopedia.com/terms/c/capm.asp). The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk .

http://www.investopedia.com/terms/c/capm.asp).

For this assignment we are going to explore CAPM in more detail. Read the article "Should managers estimate cost of equity using a two-factor international CAPM?" by Dolde, W., Giaccotto, C., Mishra, D. R., & O'Brien, T. After reading the article and doing additional research, please respond to the following questions:
1. What is CAPM? How is it used?
2. What are the advantages and disadvantages of CAPM?
3. What were the empirical findings of the study?
4. Why do they believe their findings are beneficial to U.S. managers?
5. Discuss what the authors found with regard to cost of equity difference for industries. Is one industry more susceptible than others?

Solution Preview

1. What is CAPM? How is it used?
CAPM is used when the expected return of a security or portfolio equals the rate on a risk-free security plus a risk premium. If the expected return does not meet or beat the required return, then the investment should not be undertaken. The CAPM model describes the relationship between risk and expected return and that is used in the pricing of risky securities. The formula for using CAMP is that
Ra = Rf + Ba ( Rm - rf)
Where:
Rf = Risk free rate
Ba = Beta of the security
Rm= expected market return
CAPM is used for the investors to be compensated in two ways:
Time value of money and risk. The time value of money is represented by risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensations the investors needs or taking on additional risk. This is calculated using by using a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Using CAPM model, and the following assumptions, the expected return of a stock in this CAPM can be computed. If the risk free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return ...

Solution Summary

CAPM is described and evaluated in the context of a given study which is also closely analysed for findings and benefits across industries. 882 words with references.

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