Finance - Definition, Types, Theories and Implications of CAPM

This article discusses the definition, types, and theories of finance, including personal, corporate, public, and social finance. It also explains the implications of the Capital Asset Pricing Model (CAPM) and the concept of beta value, negative beta, and security market line. The article concludes by stating that no model can give the exact value, but extreme variation in the expected value and outcome has made CAPM unreliable and difficult to work with.

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Finance
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Running head: FINANCE
Finance
Definition
Finance is the term, used to describe the study and system of money, investments and other
financial instruments including tax, government expenditures, debt issues. The finance is divided
into various types like, personal finance, corporate finance, public finance and social finance.
The main finances available for companies are debt and equity. There are numerous finance
theories, that explains the role of finance in the markets by various economists. It includes the
concept of raising and allocating money for different set of works. It is also used for managing
and controlling the asset and project details. There exist a lot of branches in finance sector, such
as rational choice theory, arbitrage pricing theory, prospect theory, legal origin theory, binomial
options pricing model and so on. Hence this finance system is a huge network sector that has
many branches on it. All the surrounding nations will have this concept that contain all the risk
divisions and the financial strategy of a nation is based on the following concepts.
Computer stock should have low beta because one of the major risks of the business is
technological development
True
A stock (also known as "shares" and "equity) is a kind of security that denotes the ownership in a
specific association and finds his claims as a part of the assets and earnings of the corporation.
With the advancement in the technology, the stock is fed and handled through computers and
electronic devices. A coin has two sides, in the same way, technological advancements have their
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set of pros and cons. With the advancement in technology, many people have been able to
expand their business, get instant updates on the stock, learn more through the web (Han & Park,
2017). But, the technology also has its share of disadvantages and threats.
The stock market, in general, one is the beta value. A computer stock, should preferably have
beta value less than one (low beta). Although it will provide low returns, it is considered to be
less risky (Aven, 2016). With the daily advancements, in the technology, the cyber crime rate has
gone up considerably. This would in-turn lead to less safety for the computer stock. Hacking,
malware, phishing is carried out easily by many individuals, which would lead the computer
stock, vulnerable to any external attack. It also leads to the information of your stock, if not
protected properly, to be viewed and misused by many hackers . This would not only, diminish
the return value, but also pose a threat to the invested money. To curtail, the cyber-crime, safety
measures and precautions must be taken prior to investing money in the computer stock. The
more money and risk is involved, the more would be the beta value and return, which would
increase the threat and multiply the risk.
Since stock A has higher expected return and lower variance than stock B, a risk averse
investor prefers investment in stock A to any portfolio composed of stocks A and B
True
A risk adverse investor is that person, who knows the risks of the market well, and would rather
prefer low returns than high returns with high risk factor. Let us take a case, where stock A has
higher expected return and lower variance. The risk adverse investor would palpably choose
stock A over any portfolio composed of stock A and B. This is because, stock A provides higher
return, with low fluctuations, and thus the risk is not high. The same cannot be said for the meld
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of stock A and stock B, as Stock B might give even better returns than stock A, but may possess
higher risk and fluctuations. If stock B also, provides lower returns, with lower variance, the
investor might opt for the combined stock. The investor always prefers the alternative with least
interest and low-risks. Hence, the given statement is true, a risk adverse investor, would prefer
investing in stock A.
Truth in the CAPM model - A Discussion
True
Capital asset pricing model (CAPM), is a subset of the finance, which is used to determine the
appropriate return rate of the asset. This helps in determining the returns, even of well-diversified
portfolio. It also provides us with the relation between systematic risks and expected return for
the assets. It acts as market equilibrium between risks, investments and returns. A few
assumptions are made by the capital asset pricing model (CAPM) that include, all investors can,
lend or borrow more money under a interest rate that is free of risk, trade without taxation or
transaction cost, maximize economic utilities (Aven, 2016).
The expected return of any portfolio can be intuited by, determining the risk premium, locating
the beta value (less than or more than one) for each asset of the portfolio and feeding the values
in the CAPM equation.
The simplistic calculations and wide range of possible outcomes, with diversified portfolio,
encouraged many investors to use the CAPM model, to calculate the approximate values of
return. But the CAPM model has various disadvantages which make it difficult for the investors
to completely rely on the outcome provided by it. The main disadvantages are the assumptions,
daily changing inputs that create volatility and negative market return. The investors may keep
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away, the risks that are company-specific. They diversify the portfolio and given the crucial
aspects of the task, they get compensated for the risks.
Sum and substance
One cannot find a perfect model. It is all about assessing the characteristics of the model to make
sure if it is applicable to the situation. CAPM is criticized for its unrealistic assumptions and
provides only an appropriate value of outcome. No model or calculation can give the exact value
but extreme variation in the expected value and outcome, has made CAPM unreliable and
difficult to work with.
Implication of CAPM
True
Beta is the measure of the volatility of the market. Negative betas are possible for investments
that tend to go down when the market goes up, and vice versa. When beta value is less than one,
it is termed as negative beta. The beta value is calculated on each and every asset of the portfolio.
If the beta value, is obtained to be less than one, that is negative beta, then the capital asset
pricing model (CAPM) determines the return might be less. The high beta value, tends to
provide more return value, compared to low beta, but the market swings and fluctuations are
high. Hence, the CAPM implies correctly that, an investment with a negative beta is expected to
provide less return than the interest rate.
If a stock lies between the security lines, it is undervalued.
False
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The capital asset pricing model graph (CAPM) is a model which portrays the relation between
the risk of a portfolio and its expected return. The security market line (SML) uses the formula of
CAPM to determine the value and expected return of the portfolio.
The Security line graph
In this graph, the beta value is set on the x-axis and the expected return is plotted along the y-
axis. The purpose of this SML graph, is to identify the value of stock, by calculating its beta
value along with the expected return. In-numerous factors like inflation, recession, change in the
interest rate etc might cause a shift or change in the slope of the graph.
Some shifts the value, might leave the market risk premium unchanged, which is the difference
between the expected return and risk-free rate. For example, the risk-free rate may shift from 2 to
5% or from 7 to 10% depending on the market condition. But in either case, the difference would
be 3%.
If a stock lies below the security line, it is overvalued. The security line is plotted on the SML
graph. Any point on the security denotes, the appropriate price of the stock. The value of the
stock depends on the value of both alpha and beta. When alpha is positive and beta value is more
than one, the investors receive high returns.
But if the stock value, which is alpha is negative and beta is less than one, then the stock is
undervalued and would produce low returns.
Hence, if the stock point is plotted below the security line, then, its beta value is plotted on the
positive x-axis and the return value is given on the positive y-axis, which determines the value of
stock to be over- valued. If the expected return versus the systematic risk is framed below the
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SML, it is given high value than necessary as the investor may accept the low returns, at the cost
of minimized risk. This would lead to a guaranteed return, even though it might be low.
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References
Aven, T. (2016). Risk assessment and risk management: Review of recent advances on their
foundation. European Journal Of Operational Research, 253(1), 1-13. doi:
10.1016/j.ejor.2015.12.023
Han, J., & Park, C. (2017). Case study on adoption of new technology for innovation. Asia
Pacific Journal Of Innovation And Entrepreneurship, 11(2), 144-158. doi:
10.1108/apjie-08-2017-031
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