Risk
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Factors Influencing Systemic Risk of a Project and How It May Differ from an Organization’s Systemic Risk When a specific project differs from the core operations of an organization, using the organization’s Weighted Average Cost of Capital (WACC) for evaluation can be a mistake. The beta of an organization’s assets may differ from the beta…
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Valuation models for derivative assets hold the same significance in finance as relativity theories do in physics… In this entry, I want to address the method of discounting with the certainty equivalent at a risk-free rate, which is used when calculating the NPV of cash flows using the usual method is impossible due to highly…
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Why is Understanding the CAPM Model Crucial for Senior Management? Given that the main task of management, particularly strategic financial management, is to increase the value of the organization, and because growth is difficult to achieve if it can’t be measured, knowledge of the CAPM (Capital Asset Pricing Model) is extremely important and yet sufficiently…
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If you plan to profit from investing in stocks, take a close look at this graph. The graph highlights two significant phenomena that the Capital Asset Pricing Model (CAPM) fails to explain. First, high Book-to-Market stocks (Value Stocks) yield higher returns compared to low Book-to-Market stocks (Growth Stocks), and small companies yield higher returns compared…
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Regardless of the level of diversification, why is it more rational to invest in a low β portfolio than a high β one? The issue is that CAPM’s predictions and actual statistics diverge. As the graph shows, low β portfolios generate higher returns than CAPM predicts, and vice versa. Although high β portfolios generate higher…
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The Fama-French three-factor model predicts the risk-return relationship better than CAPM.(Nobel Laureate Eugene Fama and researcher Kenneth French, former professors at the University of Chicago Booth School of Business). The three-factor model is an improved version of CAPM. Before this model was developed, there was also the Arbitrage Pricing Theory (APT), which posits that returns…
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How Does Financing Structure Affect Risk? In essence, the financing structure does not impact the value of an organization. Value is created by the assets, and it doesn’t matter how the cash flows generated by these assets are distributed among the financing sources. Because the cost of debt is lower than the cost of equity,…