CAPM

The CAPM model (Berk, 2011:357) explains the relationship between risk and expected returns. The following assumptions are applied:

·         Investors can borrow and lend at risk free rates

·         All investors are rational and risk adverse

·         All investors receives the same information and that information are costless

·         The markets are perfect, thus no tax, inflations or transaction cost are taken into account

·         Investors have same expectations regarding risk and expected returns of security

With the given information and assumptions, the expected returns can be derived using the CAPM formula as below:

E(r) = Rf + B(Rm – Rf)

Where:

E(r) = 3% + (1.2) (12% – 3%) = 3% + (1.2 x 9%) = 13.8%

Based on the calculations above, investors can expect a rate of return of 13.8% to compensate for the stock’s individual risk, stock market’s risk and the risk free rate interest. From the beta given, it denotes volatility greater than 1 and implies that the stock probably represents stock from a technology company.

A limitation to note is that the expected return derived is based on historical data and may not guarantee the returns as expected. (Investors Chronicle, 2001)