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Chapter 14

5.3 Systematic risk and betas

 A key concept with CAPM is that it only considers 'systematic risk', so
assumes the investor is well-diversified.

 Systematic risk is measured using beta factors.

 Beta = systematic risk of project ÷ typical level of systematic risk in the market:

– ß = 1 denotes average systematic risk

– ß > 1 for a riskier than average investment

– ß < 1 for a lower risk than average investment.

5.4 Required rate of return

 Required return = risk free rate + premium for systematic risk.

 Required return = risk free rate + ß × typical equity risk premium (ERP).

 Required return = R f + ß × (R m – R f)

 The required return can often be interpreted as a cost of equity.

 If drawn as a graph, this shows the 'Securities Market Line'.

5.5 Criticisms of the CAPM model

 Single period model – e.g. R f could change going forwards.

 Beta values are based on historic data.

 Market assumed to be perfectly efficient.

 No transaction costs.

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