The relevant risk of a stock: The capital asset pricing model (CAPM)

A model that explains the connection between the expected return and risk of investing in
securities is called the Capital Asset Pricing Model (CAPM). It demonstrates that a security's
expected return is equal to the risk-free return plus a risk premium that is calculated using the
security's beta
In other words, the relationship between systematic risk and expected return for assets,
particularly stocks, is described by the Capital Asset Pricing Model (CAPM). 1 CAPM is
frequently used in finance to value hazardous securities and calculate projected returns for
assets given their risk and cost of capital.
Beta is used in the capital asset pricing model (CAPM), which describes the relationship
between systematic risk and expected return for assets (usually stocks). The CAPM approach is
frequently used to value hazardous securities and to predict projected returns of assets while
taking into account both the risk of those assets
and the cost of capital.

Example

Let's calculate the Capital Asset Pricing Model

(CAPM) method to determine the expected
return on a stock. Let's say the following facts
regarding a stock are known:It trades on the
NYSE and its operations are based in the
United States

• A 10-year Treasury note currently

has a 2.5 percent yield.
• The long term average excess annual return for U.S. stocks is 7.5%.
• The stock's beta value is 1.25. (meaning its average return is 1.25x as volatile as the
S&P500 over the last 2 years)What is the expected return of the security using the
CAPM formula?

Using the formula from the article above, let's analyse the response:

• Expected return = Risk Free Rate + [Beta x Market Return Premium]

• Expected return = 2.5% + [1.25 x 7.5%]
• Expected return = 11.9%
Contribution to market risk: Beta
Thus, beta is a useful measure of an individual asset's contribution to the market portfolio's risk
when it is added in small quantity. Thus, beta is referred to as an asset's non-diversifiable risk, its
systematic risk, market risk, or hedge ratio. Beta is not a measure of idiosyncratic risk.
Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared
to the market as a whole (usually the S&P 500). Stocks with betas higher than 1.0 can be
interpreted as more volatile than the S&P 500.

Beta allows for a good comparison between an individual stock and a market-tracking index
fund, but it doesn’t offer a complete portrait of a stock’s risk. Instead, it’s a look at its level of
volatility, and it’s important to note that volatility can be good and bad. Investors aren’t
complaining about upward price movements. The downward price movement, of course, will
keep people up at night.

Consider evaluating the beta of various stocks like you would ordering meals at a restaurant.
Similar to how someone with a simpler palette might prefer to eat a plain dish with well-known
ingredients and flavours, if you are a more risk-averse investor who is focused on making
income, you might shy away from high-beta companies. Similar to how an adventurous eater
seeks out new, spicy dishes with exotic ingredients they have never tried, a more aggressive
investor with a higher risk tolerance may be more motivated to follow the high-beta equities.
Estimating beta
Since the CAPM is an ex ante model, each variable in it represents an expected value prior to the
occurrence of the event. Particularly, the relationship between a stock's anticipated return and the
market's anticipated return over a specific period of time should be reflected in the beta
coefficient employed by investors. However, most individuals compute betas using information
from a previous time period and then believe that the stock's risk would remain constant over the
long term.