Modern Portfolio theory elaborately discusses the relationship between the risk and the return. (Lintner, 1965. Brealey and Myers, 2003)
Goldman Sachs, one of the largest banks, is the firm, which will be studied in this paper. Before calculating the rate of return that is expected on the investment in the shares of this company employing CAPM, it is required to briefly discuss this model for the betterment of the understanding.
Whether an individual will be interested in investing his money in the shares of a particular firm depends on the exposure of the firm to the market risks as well as those risks, which are mainly specific to this firm. Now portfolio theory suggests that instead of making investment in one particular share, it would be wiser for an individual to invest in a diversified portfolio. An appropriate diversification reduces total level of risks. (Brealey and Myers, 2003. Markowitz, 1991. Bernstein, 2001)
To estimate expected return on an investment in a particular stock, Capital Asset Pricing Model is used. This model specifies a formula, which is generally applied by the firms to determine market return on the shares of that firm. CAPM takes into account only those risks, which are non-diversifiable. These risks are commonly known as systematic or market risk and they are often expressed by the term beta (β). (Markowitz, 1991. Bernstein, 2001. Tobin, 1958 )
E(Ri) = Rf + β (E(RM) – Rf). where E(Ri) is expected return on the ith capital asset, Rf is the return on the risk free asset, β represents sensitivity of the return on the stock to the market return, and E(RM) stands for the expected return on the market portfolio. (Markowitz, 1991. Bernstein, 2001)
Before moving into further analysis it is necessary to understand what risk free and risky assets stand for.