![]() ![]() The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they have issued. The risk which cannot be eliminated by portfolio diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial system. There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not eliminate risk entirely. By diversifying investments in a portfolio, therefore, an investor can reduce the overall level of risk faced. In fact, it has been found that the risk of the portfolio is less than the average of the risks of the individual investments. If an investor has a portfolio of investments in the shares of several different companies, it might be thought that the risk of the portfolio would be the average of the risks of the individual investments. ![]() The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. Investors take the risk of an investment into account when deciding on the return they wish to receive for making the investment. Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the investment will be different from the expected return. Two further articles will look at applying the CAPM in calculating a project-specific discount rate, and will look at the theory, and the advantages and disadvantages of the CAPM. This article introduces the CAPM and its components, shows how it can be used to estimate the cost of equity, and introduces the asset beta formula. Section E of the Study Guide for Financial Management contains several references to the Capital Asset Pricing Model (CAPM). An introduction to professional insights.Virtual classroom support for learning partners.Becoming an ACCA Approved Learning Partner. ![]()
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