# FIN 300 Study Guide - Quiz Guide: Capital Asset Pricing Model, Risk-Free Interest Rate, Equity Premium Puzzle

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**preview**shows pages 1-3. to view the full**9 pages of the document.**Financial Securities

Chap 6, 9, & 10 Test Review

Yield (first component of Return):

Yield is the income component of a security’s return. The issuer makes this payment

in cash to the holder of the asset periodically in return for their investment.

Capital Gain/Loss (second component of Return):

Capital gain or loss is the depreciation or appreciation in a security’s price over time.

It can be measured as the difference between the sale price and the subsequent

price, if the difference is negative, then the investor is at a capital loss, if it is positive,

then they are at a capital gain.

Total Revenue Formula:

To calculate total revenue, simply add up all revenue values given.

Ex – Revenue for 2003 was $6000, for 2004 was $10,000, and for 2005 was $20,000.

What is the total revenue in 2005?

Answer – 6000+10,000+20,000=$36,000

Investing in Bonds & Shares:

Bonds have a smaller yield in the short term than shares (stocks) do; however, since

the risk in Bonds is very minimal, they typically result in a greater Capital Gain in the

long term.

The yield of shares (stocks) is determined by the risk level of the investment.

Typically, the greater the risk of the investment, the greater the yield.

Types of Risk:

SR – Systematic Risk – Risk that affects companies on a macro scale

1) Interest Rate Risk (SR) – Variability in the return of a security due to changes in

the interest rate

2) Market Risk (SR) – Variability in the return of a security due to fluctuations in

the market

3) Inflation Risk (SR) – Variability in the return of a security due to inflation, this is

closely tied with the interest rate risk as interest rates typically increase as

inflation is occurring

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4) Exchange Rate Risk (SR) – Variability in the return of a security due to currency

fluctuations, international investors are the most who are affected by this

5) Country Risk (SR) – Variability in the success of companies that deal

internationally as a result of political or economic turmoil in the country

wherein which the company exists

NSR – Non-Systematic Risk – Risk that affects specific & individual companies

1) Business Risk (NSR) – The risk of doing business in only one specific industry

2) Financial Risk (NSR) – The risk in having a company financed mostly by debt,

which results in much lower returns (Companies can’t pay shareholders if they

can’t pay creditors)

3) Liquidity Risk (NSR) – The risk of company’s inability to be liquid (bought and

sold) in the stock market, thus leading to no change in the value of stock

Risk Prevention:

Risk cannot be prevented, but it can be controlled. Risk control is done through beta

calculations, and the CAPM formula. Another way to control risk is to diversify your

investments.

Total Return:

- Total return is the percentage measure relating all cash flows on a security for

a given time period to its purchase price

- 2 components of TR are yield & price change

- If ending price of stock is > beginning price, and dividends are low, TR is

negative

- TR is calculated with this formula,

- Where,

TR = Total Return

Yield = Dividend paid by company

Pe = The most recent price of the stock

Pb = The paid price of the stock

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CAPM:

The Capital Asset Pricing Model (CAPM) relates the required rate of return for any

security with the market risk for that security as measured by beta. Since CAPM is

only an estimation, there are 8 assumptions that are always made when calculating

CAPM so as to maintain consistency in results

1) All investors have identical probability distributions for future rates of return

2) All investors have the same one-period time horizon

3) All investors can borrow or lend money at the risk-free rate of return

4) There are no transaction costs

5) There are no personal income taxes

6) There is no inflation

7) No single investor can affect the price of stock through his buying/selling

decisions.

8) Capital markets are in equilibrium

The formula to calculate CAPM’s required rate of return is as follows:

K(i) =RF + B(i) [ E(Rm) –RF]

Where,

K (i) = required rate of return of investment ‘i’

RF = risk free rate of return

B(i) = Beta coefficient of investment ‘i’

E(Rm) = Expected rate of return on the market portfolio

Beware that in many cases, the expected rate of return is not given and must be

calculated by using this formula (or variations of it based on the data given):

E(Rm) = E(Rp) + RF

Where,

E(Rm) = Expected rate of return on the market portfolio

E(Rp) = Equity risk premium

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