| In this final article on finance we're going | | | | |
| to review some finance theories. There are | | | | Then there is the SML or Security Market |
| plenty of them to go around. | | | | Line. |
| | | | |
| Finance theories themselves are the | | | | How does this relate to the CAPM formula? |
| foundations for understanding the role of | | | | Actually, the SML is a graphical |
| finance in markets. It is a way of measuring | | | | representation of the CAPM. This tells us |
| investment value and risk and return on | | | | that if a security is priced accurately the |
| investment. Some of the theories include | | | | expected return of the security will meet the |
| foreign currency transactions, value at risk | | | | security beta at the securities market line. |
| and portfolio theory, which is the basis of | | | | However, if it falls below the line then that |
| investment analysis. An example of | | | | means the security is undervalued and |
| investment analysis is the CAPM model. | | | | overvalued if it falls above the line. In |
| | | | either case, adjustments have to be made. |
| CAPM stands for Capital Asset Pricing Model. | | | | |
| This is fundamental to all finance theory. | | | | All of this leads to the theory of risk |
| The CAPM model tries to explain the | | | | management itself, which you could write |
| relationship between risk and return on | | | | several books on alone. However, we won't |
| investment. This risk includes both | | | | attempt that here. Instead we'll just do a |
| systematic and unsystematic risk. | | | | brief overview of risk management. |
| | | | |
| Systematic risk is the risk factor common to | | | | Risk management is trying to identify, |
| the whole economy and the risk associated | | | | control and minimize the financial impact of |
| with investments in general. These are also | | | | events that cannot be predicted. By |
| non diversified risks, meaning they are | | | | minimizing potential risk, a company can |
| invested in one area. | | | | minimize the potential loss associated with |
| | | | that risk. |
| Unsystematic risk is the unique risk | | | | |
| associated with a company such as bad | | | | The ways that companies do this is through |
| management, strike or disaster and with | | | | diversification of investments. A company |
| diversification, can be eliminated or at | | | | might do any one of the following to |
| least lessened. | | | | diversify and reduce risk including long term |
| | | | forward contracts, currency swaps, cross |
| Only systematic risk is compensated for in | | | | hedging and currency diversification. By |
| regard to the investor. | | | | doing these things a company is placing it's |
| | | | funds in various areas so that if one area is |
| Here is the CAPM formula for you | | | | hit hard by something unforeseen the other |
| mathematicians out there.re = rf + beta (rm - | | | | areas should be unaffected. So whatever |
| rf)rf is the risk free rate. This is the | | | | diversification is done should be done with |
| rate that the investor gets for no risk. | | | | careful planning to ensure the areas invested |
| rm is the risk of the market as a whole in | | | | in do not overlap each other. This makes it |
| general. re is the expected return | | | | highly unlikely that multiple areas are |
| incorporating the risk free rate, market risk | | | | affected by one event. |
| and beta value. | | | | |
| | | | The above is simplified but should give you a |
| In the ideal world you want to maximize your | | | | start to the world of finance theory and risk |
| re while minimizing the risk factor. | | | | management. Future articles will go into |
| Sometimes this is not always easy or | | | | more detail. |
| possible. But this is what you shoot for. | | | | |