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How is market risk measured for individual securities?
 Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio.  It is measured by a stock’s beta coefficient, which measures the stock’s volatility relative to the market.  What is the relevant risk for a stock held in isolation?

How are betas calculated?  Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis.  The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient, or b.

Use the historical stock returns to calculate the beta for KWE.
Year 1 2 3 4 5 6 7 8 9 10 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% -13.1% KWE 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0% 25.0%

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Calculating Beta for KWE
40% 20% 0% -40% -20% -20% -40% kKWE = 0.83kM + 0.03 R = 0.36
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kKWE

kM 0% 20% 40%

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How is beta calculated?
 The regression line, and hence beta, can be found using a calculator with a regression function or a spreadsheet program. In this example, b = 0.83.  Analysts typically use four or five years’ of monthly returns to establish the regression line. Some use 52 weeks of weekly returns.

How is beta interpreted?  If b = 1.0, stock has average risk.  If b > 1.0, stock is riskier than average.  If b < 1.0, stock is less risky than average.  Most stocks have betas in the range of 0.5 to 1.5.  Can a stock have a negative beta?

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00 0.0 1.0%.8% = 7%. bi SML and Investment Alternatives 2 .7 1.7 k 17.kRF) = 15% .12 ki (%) SML: ki = kRF + (RPM) bi ki = 8% + (7%) bi Calculate beta for a portfolio with 50% HT and 50% Collections bp = Weighted average = 0. .0%.0% + 9.68) 8.0% + (7%)(1.0 12.10 Required Rates of Return Expected versus Required Returns ^ k 17.0 1.8%.4% 15. kM = kM = 15%. kM = 15 kRF = 8 Coll.86) = 15. 17.0 2.11 6 .29 1.0 13.0% + (7%)(0.6-7 6-8 Expected Return versus Market Risk Security HT Market USR T-bills Collections Expected return Risk.29) + 0.0% + (7%)(1. . = = = = 8. = 2.4% 15.68 0.5(bHT) + 0.00) 8. = 8.  SML: ki = kRF + (RPM)bi .8 8.0%.0% + (7%)(-0.86) = 0. HT Market USR T-bills Collect 6 .00 -0.86  Which of the alternatives is best? 6-9 6 .0% Undervalued 15. ^  RPM = (kM .  Assume kRF = 8%.0 Fairly valued Undervalued Fairly valued Overvalued kHT kM kUSR kT-bill kColl = 8.0% + (7%)(0.8 8. T-bills .5(1.0 13.8 8. USR Market 0 1 2 Risk.5(-0.  The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM).0%.5(bColl) = 0.22.00) 8.0% = 17.29) = 8. b Use the SML to calculate each alternative’s required return. HT . = 12. -1 .

edu  MSN Messenger or Net Meeting: mba8622@hotmail.13 6 . investors’ required returns are based on future risk.6 .0 Impact of Risk Aversion Change Required Rate of Return (%) kM = 18% kM = 15% 18 15 8 6 .0 Risk. The statistical tests have problems that make empirical verification virtually impossible. SML1 ∆ RPM = 3% Original situation 1.5 1.5(2%) = 9.5%.14 What is the required rate of return on the HT/Collections portfolio? kp = Weighted average k = 0.17 Got questions? Get answers!! Email: mba8622@hotmail.22) = 9.16 After increase in risk aversion SML2 Has the CAPM been verified through empirical tests?  No.0 1.com or chodges@westga. but betas are based on historical data.  Furthermore. bi 6 .com  Telephone: (770)836-6469 3 .5 2.0% + 7%(0.5(17%) + 0. Or use SML: kp = kRF + (RPM) bp = 8.5%. Impact of Inflation Change on SML Required Rate of Return k (%) ∆ I = 3% New SML 18 15 11 8 SML2 SML1 Original situation 0 0.  Investors may be concerned about both stand-alone risk and market risk.15 6 .