Some of the companies in your portfolio may experience unanticipated adverse conditions, like

an unannounced strike. This immediate adverse condition may be offset by unexpected good
fortune of other firms in your portfolio. However, stock prices and returns tend to move in
tandem, and not all variability can be eliminated through diversification.
It is preferable to divide a security's total risk into a portion that is peculiar to a specific firm
and can be diversified away (called unsystematic risk) and that portion that is market related
and non-diversifiable (called systematic risk):
Total risk = Unsystematic risk (diversifiable risk, firm-specific) + Systematic risk (non-
diversifiable risk, market-related)
As the number of securities is added to a portfolio, the total risk is reduced.

Figure 1: ELIMINATION OF UNSYSTEMATIC RISK THROUGH DIVERSIFICATION - As securities

are added to a portfolio, the total risk is reduced. The remaining systematic risk is market
related.

CAPITAL ASSET PRICING MODEL

The CAPM provides insight into the market's pricing of securities and the determination of
expected returns. Therefore, it also has a clear application in investment management. The
model relates to a firm's cost of equity capital and the cost of equity for the market as a whole.
The tool will arm you with a simple equation to assist you in optimizing your investment
decision and the creation of your portfolio. The CAPM is an idealized view of how the market
prices securities and determines expected returns. It provides a measure of your risk premium
and a method of estimating the market's risk-expected return curve. The assumption of the
model results in a world where investors hold diversified portfolios to minimize risk. The only
risk that an investor is sensitive to is systematic or market-related risk. The idea is that
variations in returns from one security will likely be canceled by complementary variations in the
returns of other securities in your portfolio. You are rewarded with a higher expected return for
holding market-related risks. The result of the CAPM is that a security's return is related to the
portion of risk that cannot be eliminated by portfolio combination.

CAPM provides a convenient measure of systematic risk. This measure is known as beta (β) and
gauges the tendency of a security's return to move in parallel with the overall market's return. A
good way to think of β is as a measure of a security's volatility relative to the market's volatility.
If the stock has a beta of 1.0, it tends to rise and fall the same percentage as the market 

Accordingly, β = 1.0 indicates an average level of systematic risk. If beta is greater than 1.0,
the stock will change more than the market changes and will have a high level of systematic
risk, since there is greater sensitivity to market changes. A beta of less than 1.0 has a low level
of systematic risk and is less sensitive to market swings. The results determine the risk-
expected return tradeoff under the CAPM.

We know that RS = RF + Risk premium. Then the CAPM describes market behavior by

RS = RF + β (RM − RF)

This equation states that the expected return on a security is equal to the risk-free rate (R F)
plus a risk premium. The risk premium is β times the return on the market (R M) minus the risk-
free rate. We can also restate the equation

RS − RF = β (RM − RF)

which is equal to the risk premium for security S. The risk premium on a stock or portfolio
varies directly with the level of systematic risk, beta. The risk or expected return tradeoff with
CAPM is called the security market line (SML). The SML is pictured in Figure 2.
FIGURE 2: SECURITY MARKET LINE. The risk premium on a stock or portfolio varies
directly with the level of systematic risk, beta. The security market line (SML) shows
you the risk or expected return tradeoff with CAPM.

EXPECTED RETURN

The CAPM correctly describes market behavior as the relevant measure of a security's risk as its
market-related or systematic risk as measured by β. If a stock's return has a strong positive
relationship with the return on the market, a high beta, it will be priced to yield a high-expected
return. Unsystematic risk can be eliminated through diversification and it does not increase a
security's expected return. The market cares only about systematic risk.

To summarize the determination of expected return with the CAPM:

 Risk is defined as variability in return.

 You can reduce risk by holding a diversified portfolio.

 Security risk can be divided into systematic and unsystematic risk.

 Risk that can be eliminated by diversification is unsystematic risk. It is risk that is

unique to the company and not related to other firms.
  The remaining risk in a diversified portfolio is systematic risk and it is associated

with the movement of other securities and the market as a whole.

 You hold diversified portfolios to minimize risk.

 Holding a diversified portfolio allows you to be exposed only to systematic risk. You are
rewarded by a higher expected return only for holding systematic, market-related risk.
There is no reward related with unsystematic risk, because it can be eliminated through
diversification. Accordingly, relevant risk is systematic, market-related risk and is
measured by β.

 The risk or expected return tradeoff with the CAPM is SML.

 Securities are priced by Rs= RF + Risk premium or Rs = RF = β(RM − RF)

 The SML will then give us an estimate of the expected return on any security, RS

Assignment 1:

Select five securities from five different industries in two different portfolios. In one
portfolio, select securities that would yield an average beta of greater than 1.2, and in the other
portfolio, select securities that would yield and average beta of less than 1.0.