17.1 - FIN 300 Fundamentals of Finance Risk and Return Pt 3 Chapter 7 1 FIN 300 Risk and Return Pt 3 Beta vs Standard Deviation \u2022 Assuming that we are

17.1 - FIN 300 Fundamentals of Finance Risk and Return Pt 3...

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FIN 300 Fundamentals of Finance Risk and Return Pt. 3 Chapter 7 1 FIN 300 - Risk and Return Pt. 3
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Beta vs. Standard Deviation Assuming that we are already well-diversified – that we already own, practically speaking, at least 25-30 uncorrelated stocks or shares in an S&P 500 Index mutual fund We have diversified (or, smoothed) away the firm- or industry-specific variation (risk) in the stock investment However, even if we owned the entire market, we would still be exposed to some risk (variation) due to the systematic risk that affects all stocks to some extent Because we are diversified, we are no longer exposed to the total (standard deviation) risk of the stock However, we are still exposed to the remaining, systematic (or, beta) risk of the stock FIN 300 - Risk and Return Pt. 3 2
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Using Beta to Measure Risk Nevertheless, we can still evaluate each stock (on its own merits) as to how well its return compensates for risk But, we no longer use standard deviation as the measure of an individual stock’s risk Instead, we use the beta of the individual stock Beta is a measure of a stock’s systematic risk exposure that can’t be diversified away no matter how many additional stocks we own When we compare stocks’ risk we compare them on the basis of beta Beta measures the extent to which the stock’s variation co- varies with that of all of the other stocks in the market FIN 300 - Risk and Return Pt. 3 3
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CAPM and Beta We have a model that relates the beta of a stock to its expected return That model is the Capital Asset Pricing Model (known as the CAPM ”) Using the CAPM, we can plug in the beta and a few other variables to calculate the return of a stock So, assuming we are diversified, it is no longer a matter of a stocks return vs. it’s total (standard deviation risk) It’s now a matter of evaluating a stock’s return vs. it’s beta risk!
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