Capital Asset Pricing Model (capm)

Risk, Return, and the Capital Asset Pricing Model

John Marron

RISK Total Risk = Systematic + Unsystematic Risk Systematic Risk is also called Nondiversifiable Risk or Market Risk Unsystematic Risk is also called Diversifiable Risk or Unique Risk

Diversification Can eliminate some risk Unsystematic risk tends to disappear in a large portfolio Systematic risk never disappears

Beta Beta = How much systematic risk a particular asset has relative to an average asset For example: XOM: 0.65 VIAB: 1.22 YHOO: 3.56 MII Portfolio: 1.54

Capital Asset Pricing Model

Er = Rf + B{E(Rm)-Rf} Works for both individual assets and portfolios

McIntire Investment Institute Example: If Rf = 5.5% Market Risk Premium = 7% Then the MII should return: Er = 5.5% + 1.54(12.5%-5.5%) Er = 16.28%

Expected Return depends on 3 things • •

•

The time value of money (risk-free rate, Rf) The reward for bearing systematic risk (market risk premium={E(Rm) - Rf} The amount of systematic risk (Beta)