Investments Assume you have been tasked with pricing a security. Select a pricin

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Investments

Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)Assume you have been tasked with pricing a security. Select a pricing model, which can be CAPM itself or any multifactor specification, including the Fama French version. Defend your choice of pricing model. If you are specifying a multifactor model, explicitly state the risk factors you would include (e.g., GDP changes, energy prices, etc.)

Explanation / Answer

The price of a security  is set by the stock market. We will use the CAPM for describing how to calculate value or price of individual security. This model takes into account two components -

1. component for time value of money or value that compensates the investors for placing money in any investment over time. The risk-free rate is used which can be the yield on government bonds like U.S. Treasuries.

2 component for risk premium and this calculates the value the investor needs for taking on additional risk. We calculate this by taking a risk measure (beta) and the market premium (Rm-rf): the return of the market in excess of the risk-free rate.

The formula of CAPM is

Ra = Risk free rate + Risk Premium

Ra = Rf + Ba ( Rm - Rf )

Ra is the expected return for assets

Rf is the risk free rate typically rate of interest on government security or tresury bonds

Rm is the expected market return

Ba is the beta of the security or the risk associated with the security. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market, and the correlation between the two.

( Rm - Rf ) is the market premium or the return of the market in excess of the risk-free rate.

If this expected return does not meet or beat the required return, then the investment should not be undertaken.

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