CAPITAL ASSET PRICING MODEL Calculating Betas

(CAPM) • Well-diversified investors are primarily concerned

Stand-Alone Risk with how a stock is expected to move relative to the
Portfolio Risk market in the future.
Risk and Return: CAPM/SML • Without a crystal ball to predict the future, analysts
are forced to rely on historical data. A typical
What is investment risk? approach to estimate beta is to run a regression of
• Two types of investment risk the security’s past returns against the past returns
– Stand-alone risk of the market.
– Portfolio risk • The slope of the regression line is defined as the
beta coefficient for the security.
• Investment risk is related to the probability of
earning a low or negative actual return. Illustrating the Calculation of Beta

• The greater the chance of lower than expected, or

negative returns, the riskier the investment.

Breaking Down Sources of Risk

Stand-alone risk = Market risk + Diversifiable risk

• Market risk: portion of a security’s stand-alone risk

that cannot be eliminated through diversification.
Measured by beta.

• Diversifiable risk: portion of a security’s standalone risk

that can be eliminated through proper
diversification.

Capital Asset Pricing Model (CAPM)

• Model linking risk and required returns. CAPM
suggests that there is a Security Market Line (SML)
that states that a stock’s required return equals the
risk-free return plus a risk premium that reflects the
stock’s risk after diversification.

rI = rRF + (rM – rRF)bI

• Primary conclusion: The relevant riskiness of a stock

is its contribution to the riskiness of a well-diversified
portfolio.

• In other words, diversification is the key!

Beta

• Measures a stock’s market risk, and shows a stock’s

volatility relative to the market.

• Indicates how risky a stock is if the stock is held in a

well-diversified portfolio.

Comments on Beta What is the market risk premium?

• If beta = 1.0, the security is just as risky as the • Additional return over the risk-free rate needed to
average stock. compensate investors for assuming an average
• If beta > 1.0, the security is riskier than average. amount of risk.
• If beta < 1.0, the security is less risky than average. • Its size depends on the perceived risk of the stock
• Most stocks have betas in the range of 0.5 to 1.5. market and investors’ degree of risk aversion.
8-6 • Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per year.
Can the beta of a security be negative?
• Yes, if the correlation between Stock i and the Calculating Required Rates of Return
market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the regression line
would slope downward, and the beta would be
negative.
• However, a negative beta is highly unlikely.
Verifying the CAPM Empirically
• The CAPM has not been verified completely.
• Statistical tests have problems that make
verification almost impossible.
• Some argue that there are additional risk factors,
other than the market risk premium, that must be

More Thoughts on the CAPM

• Investors seem to be concerned with both market
risk and total risk. Therefore, the SML may not
produce a correct estimate of ri.

• CAPM/SML concepts are based upon expectations,

but betas are calculated using historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.
 INVESTMENT PORTFOLIO
MANAGEMENT:
THE CAPITAL ASSET PRICING MODEL

INTRODUCTION TO INVESTMENT • The variance of return is the measure of

PORTFOLIO MANAGEMENT risk inherent in investing in a single asset or
portfolio. The higher the variance, the
A portfolio is a combination of various greater the squared deviation of return from
instruments of the expected rate of return. The higher
investments. It is also a combination of securities values indicate a greater amount of risk, and
with low values mean
different risk-return characteristics. The object of a lower inherent risk.
portfolio is to reduce risk by diversification and
maximize gains. • The variance of a perfect-certainty (risk-
free) asset is zero.
PORTFOLIO MANAGEMENT
• Portfolio management means selection of
securities and constant shifting of the portfolio in
the light of varying attractiveness of the
constituents of the portfolio.

• Portfolio management includes portfolio

planning, selection and construction, review and
evaluation of securities. The skill in portfolio RISK AND RETURN
management lies in achieving a sound balance Two types of risk for individual assets
between the objectives of safety, liquidity and • Diversifiable / Nonsystematic /
profitability. Idiosyncratic Risk
• Nondiversifiable / Systematic /
• Timing is an important aspect of portfolio Market risk
revision. Ideally, investors should sell at market
tops and buy at market bottoms. Investors may Diversifiable risk can be eliminated without
switch from bonds to share in a bullish market and cost by combining assets into portfolios.
vice-versa in a bearish market.
DIVERSIFIABLE / NONSYSTEMATIC
• Portfolio management is all about strengths, RISK
weaknesses, opportunities and threats in the choice Examples
of debt vs. equity, domestic vs. international, • Firm discovers a gold mine
growth vs. safety, and many other tradeoffs beneath its property
encountered in the attempt to maximize return at a • Lawsuits
given appetite for risk. • Technological innovations
• Labor strikes
• Portfolio management is an art and science of The key is that these events are random and
making unrelated
decisions about investment mix and policy, across firms.
matching investments to objectives, asset
allocation for individuals and institutions, and Examples:
balancing risk against performance. • Business Cycle
• Inflation Shocks
• Productivity Shocks
OBJECTIVES OF PORTFOLIO • Interest Rate Changes
MANAGEMENT • Major Technological Change
1) Security / Safety of Principal • These are economic events that affect all
2) Stability of Income assets. The risk associated with these events
3) Capital growth is systematic (system wide), and does not
4) Marketability disappear in well diversified portfolios.
5) Liquidity
6) Diversification IMPLICATIONS OF
7) Tax Incentives DIVERSIFICATION
• Diversifiable / Nonsystematic /
RISK AND RETURN Idiosyncratic Risk
• When there is only one asset involved, its risk • Disappears in well diversified
and return can be measured using expected return portfolios.
and variance of return. • It disappears without cost, i.e. you
• A portfolio is a combination of more than one need not sacrifice expected return to
asset. reduce this type of risk.
• Nondiversifiable / Systematic / Market risk
• Does not disappear in well
FORMULA FOR VARIANCE diversified portfolios.
 • Must trade expected return for Formula:
systematic risk. • Level of systematic risk in a
portfolio is an important choice for an individual.

MEASURING SYSTEMATIC RISK

The Beta Coefficient is the slope coefficient in an Rm = expected return of stock market
OLS regression of stock returns on market returns: Ra = return on assets
ß = beta
Ra = return on assets

Illustration:
Beta is a measure of sensitivity: it describes how
strongly the stock return moves with the market
return.
• Example: A Stock with  = 2 will on
average go up 20% when the market goes
up 10%, and vice versa.

BETAS AND PORTFOLIOS
The Beta of a portfolio is the weighted average of
the
component assets’ Betas.
HOW CAN WE USE CAPM
Example: You have 30% of your money in
One way is to use CAPM to calculate
Asset X, which has X = 1.4 and 70% of
WACC
your money in Asset Y, which has Y = 0.8.
THE CAPITAL ASSET PRICING
Portfolio Beta is: Bp = .30(1.4) + .70(0.8) = 0.98.
MODEL (CAPM)
RECAPP:
• Given that
A beta
• some risk can be diversified,
a. Is a measure of the sensitivity of a
• diversification is easy and costless,
stock’s return to the returns on the market
• rational investors diversify,
portfolio.
• There should be no premium associated
b. A standardized measure of a stock’s
with diversifiable risk.
contribution to the risk of a well
• The question becomes: What is the
diversified portfolio.
equilibrium relation between systematic risk
c. A measure of a stock’s systematic risk
and expected return in the capital markets?
(per unit risk or relative to the risk of the
• The CAPM is the best-known and most-
market portfolio).
widely used equilibrium model of the
risk/return (systematic risk/return) relation.
HOW TO GET BETA
Beta is estimated using a regression equation.
CAPM INTUITION: RECAP
• In practice, generally use last five years
of monthly data. Some companies publish
beta estimates on a regular basis:
• Value Line, Merrill Lynch Beta
Book, S&P
• Risk free assets earn the risk-free rate
• What if the company is not publicly traded?
• If the asset is risky, we need to add a risk
• Find a comparable company that is
premium.
traded.
• The size of the risk premium depends on
• Use accounting data (ROE) instead of
the amount of systematic
stock returns.
risk for the asset (stock, bond, or investment
project) and the price
What Determines Beta?
per unit risk.
u Beta is a measure of sensitivity to the market.
• Could a risk premium ever be negative?
u Companies with cyclical cash flows will tend to
have higher betas.
u Higher operating leverage implies higher betas.
THE CAPM
u Operating leverage is the ratio of fixed costs to
variable costs.
u Higher financial leverage also means a higher
equity beta.

THE CAPITAL ASSET PRICING MODEL

(CAPM)
CAPM is an investment theory that shows the
relationship between the expected return of an
investment and the market risk.
USING THE CAPM TO SELECT A
DISCOUNT RATE
• Three inputs are required:
(i) An estimate of the risk free interest rate.
• The current yield on short term treasury bills is
one proxy.
• Practitioners tend to favor the current yield on
longer-term treasury
bonds but this may be a fix for a problem we don’t
fully understand.
• Remember to adjust the market risk premium
accordingly.

(ii) An estimate of the market risk premium,

E(Rm) - Rf
. • Expectations are not observable.
• Generally use a historically estimated value.

(iii) An estimate of beta. Is the project or a

surrogate for it traded in financial markets? If so,
gather data and run an OLS regression. If not, you
enter a very fuzzy area.

The Market Risk Premium

n The market is defined as a portfolio of all wealth
including real estate, human capital, etc.
n In practice, a broad based stock index, such as
the S&P 500 or he portfolio of all NYSE stocks, is
generally used.

n Historically, the market risk premium has been

about 8.5% - 9% above the return on treasury bills.
n The market risk premium has been about 6.5% -
7% above the return on treasury bonds.

PROBLEMS

PROBLEMS