Unformatted text preview: ured by the covariance of its returns with returns on a market index, which is deﬁned to be the asset's beta. The result: The required return on an investment will be a linear funcJon of its beta: ¤༊ Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Porlolio  Riskfree Rate) Aswath Damodaran 83 LimitaJons of the CAPM 84 1. The model makes unrealisJc assumpJons 2. The parameters of the model cannot be esJmated precisely The market index used can be wrong. ¤༊ The ﬁrm may have changed during the 'esJmaJon' period' ¤༊ 3. The model does not work well  If the model is right, there should be: n༆ A linear relaJonship between returns and betas n༆ The only variable that should explain returns is betas ¤༊  The reality is that n༆ The relaJonship between betas and returns is weak n༆ Other variables (size, price/book value) seem to explain diﬀerences in returns beCer. ¤༊ Aswath Damodaran 84 AlternaJves to the CAPM 85 Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment
Low Risk Investment
High Risk Investment E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that is specific to investment (Firm Specific)
Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio
Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio
are...
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 Fall '09

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