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CAPM and The Characteristic Line
CAPM and The Characteristic Line
measuring variability of its returns Total risk can be divided into two parts diversifiable risk (unsystematic risk) and nondiversifiable risk (systematic risk) The characteristic line is used to measure statistically the undiversifiable risk and diversifiable risk of individual assets and portfolios
Characteristic line for the ith asset is: ri,t = ai + birm,t + ei,t OR ri,t = birm,t + ai + ei,t Take Variance of both sides of Equation
VAR (ri,t) = VAR(birm,t ) +VAR(ai) + VAR(ei,t) VAR(birm,t ) = VAR (ri,t) - VAR(ei,t) OR VAR(ei,t) = VAR(ri,t) - VAR(birm,t )
Beta Coefficients
An index of risk Measures the volatility of a stock (or
Beta Coefficients
Beta coefficients are the slope of
the regression line relating the return on the market (the independent variable) to the return on the stock (the dependent variable)
Beta Coefficients
market beta
Portfolio Betas
Weighted average of the individual
asset's betas
May be more stable than individual
stock betas
asset explains the assets systematic variability of returns in terms of market forces that affect all assets simultaneously The portion of total risk not explained by characteristic line is called unsystematic risk
must be priced to yield high returns in order to induce investors to accept high degrees of risk that are undivesifiable in the market CAPM illustrates positive relationship between systematic risk and return on an asset
is the correct measure of a securitys risk. All investments and portfolios of investments must lie along a straight-line in the return-beta space Required return on any asset is a linear function of the systematic risk of that asset E(ri) = rf + [E(rm) rf] i
A macro component explains risk and return in a portfolio context A micro component explains individual stock returns The micro component is also used to value stocks
the risk free rate (rf) the return on the market (rm) the stock's beta the return on a stock: k= rf + (rm - rf)beta
provided we know the systematic risk of that asset In equilibrium, every asset must be priced so that its risk-adjusted required rate of return falls exactly on the straight line If an investment were to lie above or below that straight line, then an opportunity for riskless arbitrage would exist.
Examples of CAPM
Stocks Expected Return Beta A 16% 1.2 B 19% 1.3 C 13% 0.75 E(rm) = 18% rf = 14% Which of these stocks is correctly priced?
Example of CAPM
Given the following security market line
E(ri) = 0.07 + 0.09I What must be the returns for two stocks assuming their betas are 1.2 and 0.9?