It’s now a matter of evaluating a stock’s return vs. it’s beta risk! • Note, that if we’re not diversified – we own just the one stock – then we would go back to using the standard deviation – Use of beta hinges on owning individual stocks within a diversified portfolio FIN 300 - Risk and Return Pt. 3 4
CAPM Formula individual stock individual stock • FIN 300 - Risk and Return Pt. 3 5
Variables in CAPM • The beta ( ) of an individual stock is a measure of the covariance of the individual stock’s returns with those of the market – By “ market,” we mean a portfolio of stocks that is representative of the entire stock market – Usually, we use the S&P 500 Index as a proxy (or, a substitute) for the market portfolio • The risk-free return is the rate of return earned on a risk-free asset, such as a T-Bill • The quantity, “ R mkt - R f ” is the difference between the return on the market and the risk-free rate – R mkt – R f is known as the “market risk premium” FIN 300 - Risk and Return Pt. 3 6
Risk Premium • If one expects to earn some degree of return on a risk- free asset (such as a T-Bill) • Then, not all of the return on a risky asset (such as a stock) may be said to be compensation for bearing risk • The compensation for risk is the return earned above and beyond that of the risk-free investment • So, the risk premium (and not the return itself) is said to the be the compensation for bearing risk • The market risk premium is the difference between the market return and the risk-free rate • The risk premium of any individual stock is the difference between that stock’s return and the risk-free rate FIN 300 - Risk and Return Pt. 3 7
CAPM Graph FIN 300 - Risk and Return Pt. 3 8 Return R f (Mkt.) = 1 (R f ) = 0 R mkt Mkt Risk Prem R i i Risk Prem of i th Stock
CAPM and Beta • In the CAPM: – Beta of the market = 1 • The market is just the average beta of all stocks • If an asset has the same risk as the market portfolio, then it will have a beta of 1 – Beta of the risk-free asset = 0 • Risk-free assets have no risk • So, it stands to reason that the beta of a risk-free asset, such as a T-Bill, is zero FIN 300 - Risk and Return Pt. 3 9 Know these!
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