Question 20

CAPM provides a way to price risk.

The capital asset pricing model (CAPM) is useful because it quantifies the relationship between systematic risk and expected return, providing a framework for pricing risk in financial markets.

A) It allows for calculation of the present value of future cash flows.

This option is incorrect because calculating the present value of future cash flows typically involves discounting those cash flows at a specific rate, rather than pricing risk. While CAPM can influence the discount rate, its primary purpose is to assess the risk-return trade-off rather than to calculate present value directly.

B) It provides a way to price risk.

This option is correct as CAPM specifically addresses how to quantify the risk of an asset in relation to the market as a whole. By establishing a linear relationship between the expected return of an investment and its systematic risk, CAPM serves as a critical tool for investors in assessing risk.

C) It provides a way to value a perpetuity.

This choice is incorrect because valuing a perpetuity generally involves using a fixed cash flow and a constant discount rate, which is not the primary function of CAPM. CAPM does not specifically cater to the valuation of perpetuities but rather focuses on risk assessment.

D) It allows a discount rate to be determined.

While this statement has some truth, as CAPM can help in determining the appropriate discount rate based on risk, it is not its primary function. CAPM's main contribution lies in its ability to relate risk to expected returns, rather than solely serving as a method for discount rate determination.

Conclusion

The capital asset pricing model is fundamentally about pricing risk, which is why option B is the correct answer. Other options either misinterpret the model's purpose or focus on related financial concepts that do not directly align with CAPM's core function of linking risk and expected return.