Week08_LectureNotes_6SlidesPerPage - WEEK 8: LEARNING...

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1 FINS1613 Business Finance Lecture 8 Lecture 8: Capital Asset Pricing Model Readings: RTBWJ Chapter 11 WEEK 8: LEARNING OBJECTIVES Understand about risk Understand the risk premium for market risk Understand about diversifiable risk Understand what beta is and how to calculate it Be able to calculate portfolio betas 2 FINS1613_s2_2010_L8 WEEK 8: LEARNING OBJECTIVES Understand the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML) Understand the factors that affect the SML Understand the limitations / issues concerning the CAPM Understand the relationship between volatility and risk 3 FINS1613_s2_2010_L8 The Systematic Risk Principle For a well diversified portfolio, the only relevant risk is non- diversifiable (market/systematic) risk. – Firm-specific (unsystematic) risk is diversified away. Thus the expected return on a risky asset only depends on that asset’s market risk. – This is the systematic risk principle. – It implies that no matter how much total risk an asset has, only the systematic portion is relevant in determining expected return. • No reward for bearing firm-specific risk that can be diversified away 4 FINS1613_s2_2010_L8 Risk Premium for Market Risk A rational, well diversified, investor will be indifferent to diversifiable risk. – The investor will only expect a risk premium for market risk. Market (Portfolio Risk) is lower than the standalone risk. – So the diversified investor will be prepared to accept a lower return (pay a higher price) for an asset. 5 FINS1613_s2_2010_L8 Risk Premium and Diversifiable Risk There is no market risk premium for Diversifiable Risk There can only be one price (expected return). – The expected return must be determined by the market risk as that is what the diversified investors will accept. Therefore investors will not be able to obtain a reward for bearing the full stand-alone risk. 6 FINS1613_s2_2010_L8
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2 Beta The usual measure of market risk is Beta . – Beta represents the extend to which the returns on an asset move with the stock market – An average risk stock will move in step with the market and will have a beta of 1.0 An asset that is more volatile than the market will have a beta greater than 1.0 – An asset that is less volatile than the market will have a beta less than 1.0 7 FINS1613_s2_2010_L8 Beta (cont.) Beta measures market risk – This is the contribution of a stock to the market risk of a portfolio.
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This note was uploaded on 07/25/2011 for the course FINS 1613 taught by Professor Drkhshim during the Two '10 term at University of New South Wales.

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Week08_LectureNotes_6SlidesPerPage - WEEK 8: LEARNING...

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