# CAPM - CAPM and the Characteristic Line The Characteristic...

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CAPM and the Characteristic Line

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The Characteristic Line Total risk of any asset can be assessed by measuring variability of its returns Total risk can be divided into two parts— diversifiable risk (unsystematic risk) and non- diversifiable risk (systematic risk) The characteristic line is used to measure statistically the undiversifiable risk and diversifiable risk of individual assets and portfolios
Characteristic line for the ith asset is: r i,t = a i + b i r m,t + e i,t OR r i,t = b i r m,t + a i + e i,t Take Variance of both sides of Equation VAR (r i,t ) = VAR(b i r m,t ) +VAR(a i ) + VAR(e i,t ) VAR(b i r m,t ) = VAR (r i,t ) - VAR(e i,t ) OR VAR(e i,t ) = VAR(r i,t ) - VAR(b i r m,t )

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Beta Coefficients An index of risk Measures the volatility of a stock (or portfolio) relative to the market
Beta Coefficients Combine The variability of the asset’s return The variability of the market return The correlation between the stock's return and the market return

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Beta Coefficients
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