Page 88 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 2. It is difficult to test the validity of CAPM from a practical point of view.

3. Betas do not remain stable over time. Beta is a measure of a security’s future risk. But
investors do not have future data to estimate beta. What they have are past data about the
share prices and market portfolio. Thus, they can only estimate beta based on historical
data. This implies that historical betas are poor indicators of the future risk of securities.

!
Caution Investors can use historical data as the measure of future risk only if it is a stable
over time.

Despite the limitations of CAPM, it provides a useful conceptual framework for evaluating and
linking risk and return. An awareness of the trade-off and an attempt to consider risk as well as
return in financial decision-making should help financial managers achieve their goals.
Self Assessment

Fill in the blanks:
13. …………is a measure of a security’s risk relative to the market portfolio.

14. The CAPM can be divided into two parts which are risk-free interest and the………………..
15. ………….provides a framework for measuring the systematic risk of an individual security
and relates it to the systematic risk of a well diversified portfolio.

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Case Study Case: To Invest or Not?

ipro Company has asked the investors to invest in their securities & while
making an offer, they have provided you with the following information. For
Wa period of 10 years, company has provided you with the rate of return on
security & return on the market portfolio of its securities as:

Period Return on security WIPRO (%) Return on market portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 8
7 17 -6
8 19 5
9 -7 6
10 20 11

You as an investor have decided to invest in the securities of the company. The anticipated
return with the associated probabilities is as:

Contd...

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