Understanding Risk and Return Measures through CAPM Model and Company Context

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ACC00716 Finance Session 1, 2018
Assessment 2: Business Case Studies 1

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Introduction
This report has been developed for providing an understanding of the risk and return
measures of the part 2(a) and part 2(b). This has been carried out through developing an in-depth
understanding of the Capital Asset Pricing Model (CAPM) and the company context.
Use of CAPM Model & Company Context for Interpretation of Part 2(a) and Part 2(b)
CAPM model is used widely by the investors for determining the price of risky securities.
The model from its development is finding extensive use in determining the relation between
expected return and risk of investing in security by the investors. The model has provided the
following formula to describe the relation between the risk and return:
Required Rate of Return=Risk-free rate+ (Rate of return of Market-Risk free rate)*Beta
Beta in the above formula depicts the systematic risk associated with a security. There are
two type of risk impacting the returns realized from a security. These are systematic and
unsystematic risk. Systematic risk is the market risk that cannot be eliminated as it depends on
market volatility whereas unsystematic risk is the risk that can be reduced through creating of a
portfolio that is well-diversified. A well-diversified portfolio can be created through the use of
CAPM model through determining their expected rate of return and risk level. Diversification
intends to reduce the risky incorporating assets that have lower correlation between them. This
means there should be an adequate combination of securities with higher and lower risk so that
overall risk level of the portfolio gets reduced (Peterson and Fabozzi, 2002).
The major advantage of the use of CAPM model is that it determines the systematic risk
of securities through the calculation of beta factor which is not assessed by the use of any other
investment model. Beta also helps in determining the cost of equity in the CAPM model. The
model is finding extensive use due to its simple usage and also able to assess the potential of an
investment under various types of situations. The model has utilized certain assumptions in its
development such as investors can borrow or lend money at risk-free rate in unlimited amounts
and also their main motive is maximization of wealth. As such, investors tend to realize the
potential worth of an investment through calculating the required rate of return for a financial