What is the expected risk premium of the market What is the expected risk

What is the expected risk premium of the market what

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What is the (expected) risk-premium of the market? What is the (expected) risk-premium of the stock? FIN 300 - Risk and Return Pt. 3 15
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CAPM Examples Example 3 – Solution R i = R f + β (R mkt – R f ) 30% = 6% + 2 (R mkt – 6%) 24%/2 = 12% = R mkt – 6% Return on Market = 12% + 6% = 18% Market Risk Premium = 18% - 6% = 12% Stock’s Risk Premium = 30% - 6% = 24% FIN 300 - Risk and Return Pt. 3 16
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CAPM Examples Example 4: Given: Stock has the same beta as the market Market risk premium = 10% Risk-free return = 4% What is the (expected) return of the market? What is the (expected) return of the stock? What is the (expected) risk-premium of the stock? What is the stock’s beta? FIN 300 - Risk and Return Pt. 3 17
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CAPM Examples Example 4 – Solution R i = R f + β (R mkt – R f ) Return on Market = Mkt. Risk Premium + R f = 10% + 4% = 14% Return on Stock = 14%; Same as Market Stock’s Risk Premium = 10%; Same as market Stock’s beta = 1 (Beta of market =1) FIN 300 - Risk and Return Pt. 3 18
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Portfolio Beta What if I have a portfolio of stocks with different betas? How can I calculate the beta of the overall portfolio Answer: I apply the same math as for the portfolio return Calculate a portfolio-weighted average beta Multiply each beta by its portfolio weight Sum up the terms and that is the portfolio beta FIN 300 - Risk and Return Pt. 3 19
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Portfolio Beta Example Invest $1M in a portfolio of assets $200k invested in a stock with a beta = 0.4 $300k invested in a stock with a beta = 2 $100k invested in T-Bills (assumed to be risk-free) $400k invested in a market index fund (assumed to resemble the market portfolio) What is the beta of the overall portfolio? FIN 300 - Risk and Return Pt. 3 20
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Portfolio Beta Example Note: Beta of the risk-free T-Bills = 0 Beta of the market index fund = 1 = market beta Portfolio weights: $200k/$1M = 0.20 = 20% in beta=0.4 $300k/$1M = 0.30 = 30% in beta=2 $100k/$1M = 0.10 = 10% in beta=0 (T-Bills) $400k/$1M = 0.40 = 40% in beta=1 (Mkt) Portfolio beta = 0.20(0.4) + 0.30(2) + 0.10(0) + 0.40(1) = 0.08 + 0.60 + 0 + 0.40 = 1.08 FIN 300 - Risk and Return Pt. 3 21
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