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CAPM provides that investors are rewarded for bearing systematic risk which is attributed to stocks response to a change in the market. Systematic risk can not be eliminated and the investor has to bear this risk. Though investors are generally risk averse but they have to assume systematic risk and more they assume it the higher will be the reward. Whereas, securitys individual risk or unsystematic risk can be eliminated by diversification. So the investors are actually rewarded for assuming systematic risk.
Systematic risk is market-related risk that cannot be diversified away. Because systematic risk cannot be diversified away, investors are rewarded for assuming this risk. Each of the individual securities has its own risk (and return) characteristics, described as specific risk. By including a sufficiently large number of holdings, the specific risk of the individual holdings offset each other, diversifying away much of the overall specific risk and leaving mostly nondiversifiable or market-related risk.
Covariance measures the extent to which two securities tend to move, or not move, together. The level of covariance is heavily influenced by the degree of correlation between the securities (the correlation coefficient) as well as by each securitys standard deviation. As long as the correlation coefficient is less than 1, the portfolio standard deviation is less than the weighted average of the individual securities standard deviations. The lower the correlation, the lower the covariance and the greater the diversification benefits (negative correlations provide more diversification benefits than positive correlations).
The variance of an individual security is the sum of the probabilityweighted average of the squared differences between the securitys expected return and its possible returns. The standard deviation is the square root of the variance. Both variance and standard deviation measure total risk, including both systematic and specific risk. Assuming the rates of return are normally distributed, the likelihood for a range of rates may be expressed using standard deviations. For example, 68 percent of returns may be expressed using standard deviations. Thus, 68 percent of returns can be expected to fall within + or -1 standard deviation of the mean, and 95 percent within 2 standard deviations of the mean.
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Unsystematic Risk Each of the individual securities has its own risk (and return) characteristics, described as specific risk. By including a sufficiently large number of holdings, the specific risk of the individual holdings offset each other, diversifying away much of the overall specific risk and leaving mostly nondiversifiable or market-related risk.
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5 .
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5 .
Calculate Beta
Beta =
Excel Slope
Beta of a Portfolio: The beta of a portfolio is the weighted average of each of the stocks betas
Stock A B C D
Stock A B C D
Sakina has Rs. 35,000 invested in a stock which has a beta of 0.8 and Rs. 40,000 in a stock with a beta of 1.4. If these are only two investment in her portfolio what is her portfolio beta
Briefly explain whether investors should expect a higher return from holding Portfolio A versus Portfolio B under capital asset pricing theory (CAPM). Assume that both portfolios are fully diversified. ` Portfolio A Portfolio B Systematic risk (beta) 1.0 1.0 Specific risk for each individual security High Low
= =
6 +(8 6) *(1.5) 9
Stock U N D
(Required Return) E(Ri) = .10 + .04Fi .10 + .04(.85) = .10 + .034 = .134 .10 + .04(1.25)= .10 + .05 = .150 .10 + .04(-.20) = .10 - .008 = .092
E(RD) = .08 + .06(0.44) = .08 + .0264 = .1064 = 10.64% E(RE) = .08 + .06(0.03) = .08 + .0018 = .0818 = 8.18% E(RF) = .08 + .06(-0.79) = .08 - .0474 = .0326 = 3.26%
Total 4,000,000 If the market required rate of return is 14% and the risk free rate is 6%, what is the funds required rate of return.
Risk Free Rate of Return is 8% Calculate (a) (b) Required Rate of Return State whether the security is undervalued or over valued
Excess Stock Return = Stock Return Risk Free Rate of Return Exess Market Return = Market Return Risk Free Rate of Return
Excess Return = Exess Market Return * Beta Excess Return = C + Excess Market Return + Excess Return = 0+ Excess Market Return + 0
= =
6 +(8 6) *(1.5) 9
Total 4,000,000 If the market required rate of return is 14% and the risk free rate is 6%, what is the funds required rate of return.
Risk Free Rate of Return is 8% Calculate (a) (b) Required Rate of Return State whether the security is undervalued or over valued
(a). The security market line (SML) shows the required return for a given level of systematic risk. The SML is described by a line drawn from the risk-free rate: expected return is 5 percent, where beta equals 0 through the market return; expected return is 10 percent, where beta equal 1.0.
Calculation of alphas: Stock X: = 12% - [5% + 1.3% (10% - 5%)] = 0.5% Stock Y: = 9% - [5% + 0.7%(10% - 5%)] = 0.5% In this instance, the alphas are equal and both are positive, so one does not dominate the other.
By increasing the risk-free rate from 5 percent to 7 percent and leaving all other factors unchanged, the slope of the SML flattens and the expected return per unit of incremental risk becomes less. Using the formula for alpha, the alpha of Stock X increases to 1.1 percent and the alpha of Stock Y falls to -0.1 percent. In this situation, the expected return (12.0 percent) of Stock X exceeds its required return (10.9 percent) based on the CAPM. Therefore, Stock Xs alpha (1.1 percent) is positive. For Stock Y, its expected return (9.0 percent) is below its required return (9.1 percent) based on the CAPM. Therefore, Stock Ys alpha (-0.1 percent) is negative. Stock X is preferable to Stock Y under these circumstances.
Over vs. Undervalue Stock A is overvalued because it should provide a 16.5% return according to the CAPM whereas the analyst has estimated only a 16.0% return. Stock B is undervalued because it should provide a 12.5% return according to the CAPM whereas the analyst has estimated a 14% return.
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E(Ri) = RFR + Bi(RM - RFR) = .08 + Bi(.15 - .08) = .08 + .07Bi Stock Beta E(Ri) = .08 + .07Bi Intel 1.597 .08 + .1118 = .1918 Ford .883 .08 + .0618 = .1418 Anheuser Busch .767 .08 + .0537 = .1337 Merck 1.123 .08 + .0786 = .1586