Camp Model



Analytical Methods in Economics and Finance

Introduction

CAPM is a financing model used to evaluate the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the capital asset pricing model only reimburses investors for the systemic risk of the holding a portfolio since specific risk can be diversified away. Risk in the capital asset pricing model is assumed as wanting to be avoided but if risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk free return rate. It should be noted, however, that the capital asset pricing model is valid under certain assumptions.

Financial managers that are equipped with this information can make financial decisions. The capital asset pricing model is a powerful tool for corporate capital budgeting and performance measurement. The CAPM takes into account the sensitivity of the asset at risk non-diversifiable, known as market risk or systematic risk, represented by the symbol of Beta (ß), as well as expected market return and the expected return of an asset theoretically risk-free.

A key variable used in determining asset price in the CAPM model is the return on the market. This variable is essential because any change in the market return has a significant impact on the return expected by an investor. The market for this model is considered to be all investments in all markets, including commodities and investments. However, the value that is used is a substitute or proxy for the total market valuation a market index such as the S&P 500.

Answer a)

The above graph represents the monthly return on Mobil-Exxon (XOM) against the rate of return on the market portfolio (MKT). The trend of market portfolio is from 1998 to 2008 is much more in positive trend than the return on Mobil-Exxon (XOM) which has been in negative in most of the month. These two variables has been fluctuating in t his entire 10 periods due to the fact that these two variables have positive correlation in which when market portfolio return increase or decrease the stock return also increase or decrease but in same situation like during Dec 2000 and Jan 2001, there has been a negative correlation in which return on XOM is decreasing while MKT is increasing. Hence, the illustration state that the return on stock and return on market portfolio do not vary together in consistent manner. Moreover, it also illustrate that there is no strong correlation among these returns (Agresti A., 2011, pp. 49).

Answer b) Risk premium on Microsoft and the risk premium on the market portfolio for the entire period, using the data for “MSFT”, “MARKET” and “RKFREE”

The following is the risk premium on Microsoft and the risk premium on the market portfolio from the period of 1998 and 2008. The formula to calculate Risk premium is as followed: ...