Finance Theory

Finance theories underlie the fundamentals in understanding finance and its role in markets. From measuring investment value, risk and return on investment, exposure to foreign currencies provide important tools for finance graduates.

Some of these theories includ foreign currency transactions, value at risk and porfolio theory. Portfolio theory forms the basis of investment analysis and an example of this is the CAPM model

CAPM (capital asset pricing model)

Fundamental to finance theory the CAPM model trys to explain the relationship between risk and return on an investment. This risk incorporates both systematic and unsystematic risk.

Systematic risk is the risk factor common to the whole economy and risk associated with investments in general which is non-diversifiable.

Unsystetmatic risk is associated uniquely within a company such as bad management , strike or disaster and through diversification can be eliminated..

. Because unsystematic risk can be diversified , only systematic risk is compensated for the investor..

CAPM formula.

rc = rf + beta (rm – rf).

  • In the CAPM model the beta variable is associated as systematic risk
  • rf = is the risk free rate, this is important because this is the rate iinvestor could be getting for no risk.
  • rm = is the risk of the whole market in general
  • re = is the expected return incorporating the risk free rate, market risk and beta value

  • What is the Security Market Line?

    SML which is the security market line is a graphical representation of the CAPM model

    This tells us that if a security are priced accurately the expected return of the securities meets the securities beta at the security market line

    However if they are below they line they are overvalued, but if they are above the line their overvalued.