its beta risk Note that if were not diversified we own just the one stock then

# Its beta risk note that if were not diversified we

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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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• Fall '08
• Olander