Types of Risk

◼ Market Risk – systematic/non diversifiable

risk
◼ Unique Risk – non systematic/diversifiable
risk
 Capital Asset Pricing Model
◼ CAPM explains the relationship between risk
and return for a particular security.
 Assumptions
◼ Investors want to maximise the expected returns on
their portfolio.
◼ Investors are risk averse
◼ Investors have homogenous expectations of risk and
return
◼ Investors have identical time horizon
◼ Individuals can borrow and lend freely at a riskless
rate of return
◼ The market is perfect: there are no transaction costs
& securities are completely divisible
◼ Information is freely and simultaneously available to
all investors
E (Rj) = R f + b j ( E (Rm) – R f)
E (Rj) = Expected return on security j
Rf = return on risk free security
B j= volatility of security j with respect to the
market portfolio
E (Rm) = Expected return on the market
portfolio.

E (Rm) – R f =Market risk premium

◼ Expected return on a security j = Risk free
return +( market risk premium* beta of
security j)
 Risk free rate
◼ The return on a security that is free from
default risk

◼ Eg: Return on a short term government

security like a 364 days treasury bill
◼ The return on a long term government bond
with a maturity period of 15-20 years
 Market risk premium

◼ It is the amount above the risk-free rate

required to induce average investors to enter
the market
◼ It is the difference between the average
return on stocks in the portfolio and the
average risk free rate
◼ Use maximum possible historical period
◼ Use arithmetic mean
 Beta
◼ Beta measures the volatility of the security. It
describes how the expected return of a stock
or portfolio is correlated to the return of the
financial market as a whole.
 Security Market Line
◼ A security market line is a linear relationship
between risk and return.
◼ Under priced securities are plotted above the
SML
◼ Overpriced securities are plotted below the
SML
◼ The difference between the actual (expected
)return on a security and its fair return as per
the SML is called alpha
◼ The risk free return is 5% and the expected
return on the market portfolio is 14%.The
beta of the stock is 1.25.Find the fair return of
the stock as per SML.
◼ If stock beta is 1.2, the risk free rate is 4 and
market rate of return is 14 %, what is the
market risk premium?
◼ Security market line (SML) is the
representation of the CAPM. It displays the
expected rate of return of an
individual security for its systematic, non-
diversifiable risk
Security Market Line