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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- Finance, Capital Asset Pricing Model, Corporate Finance, Ri, Return Pt.