1. The formula for the capital asset pricing model is: K i = R F + B i (K M - R
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Question
1. The formula for the capital asset pricing model is:
Ki = RF + Bi (KM - RF)
Ki is the required rate of return that we are solving for; RF is the risk-free rate, and we shall assume it is 4.6 percent; Bi is the systematic risk of a stock that we will esimate; (Km - RF) is the equity risk premium or the amount the market is assumed to earn over the risk-free rate in the long term. We will use 6.4 percent in this example.
2. Now we are in a position to esimate the beta for a company and comptue Ki , the required rate of return.
While Value Line, Bloomberg, and other financial services provide esimates of beta, they are often very different. In this exercise, we are going to have you eyeball a value for beta. Go to finance.yahoo.com
3. Enter Oracle (ORCL) in the search box on the left and click "Get Quotes."
4. Along the left margin, click on Basic Chart
5. Then on the "Range" line, click on "2y"
6. Then on the "Compare" line, select S&P 500 and click "Compare."
7. Eyeball the relative volatility of ORCL to the Standard & Poor Index (GSPC) and estimate a beta (such as 1.1 or 1.3) based on the realitve volatility of the stock versus the index.
8. Use this beta and the previously presented information on RF and (KM -RF) to compute Ki
10. What conclusion can you draw between the relationship of beta (bi), a risk measure, and the required rate of reutrn (Ki)?
Explanation / Answer
Answer: Ki = the return being estimated
Bi = the beta; the systematic risk of the stock. Taken from www.yahoo.finance.com
Rm = the return for the market (index is used) = 6.4%
RF = the risk –free rate (normally a government rate on a financial instrument) = 4.6%.
The Capital Asset pricing model (CAPM) is a model that describes the relationship between risk and the expected return and that is used in the price of risky securities. The model states that Returns (Ki) will be determined through the formula Ki=Rf+Bi (Rm-Rf)
Beta for MCD=.36
Ki=4.6%+.36(6.4%-4.6%)
=.023 (2.3%)
Ki=4.6% +.36(6.4%)=6.9%;
The risk premium (6.4%) was given
Beta for BAC=2.76
Ki=4.6% + 2.76(6.4%-4.6%)=.1763 (17.63%)
Beta for KO=.59
Ki=4.6%+.59(6.4%-4.6%)=.0377 (3.7%)
The correlation of Beta (Risk) to Return shows us that the higher the risk, the higher the expected return.
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