Risk & Return

Contribution to Market Risk: Beta

The relevant risk of an individual stock, which is called its beta
coefficient, is defined under the CAPM as the amount of risk that the
stock contributes to the market portfolio.

The tendency of a stock to move up and down with the market is

reflected in its beta coefficient.
 Contribution to Market Risk: Beta

• An average-risk stock is defined as one with

a beta equal to 1.0. Such a stock’s returns
tend to move up and down, on average,
with the market.
• A portfolio of b = 0.5 stocks will be half as
risky as the market.
• A portfolio of b = 2.0 stocks will be twice as
risky as the market.
 Portfolio Betas
The beta of a portfolio is a weighted average of its individual
securities’ betas:

Thus, since a stock’s beta measures its contribution to the risk of a

portfolio, beta is the theoretically correct measure of the stock’s risk
 Example-1
An investor has a three-stock portfolio with $25,000 invested in Dell,
$50,000 invested in Ford, and $25,000 invested in Wal-Mart. Dell’s beta
is estimated to be 1.20, Ford’s beta is estimated to be 0.80, and Wal-
Mart’s beta is estimated to be 1.0. What is the estimated beta of the
investor’s portfolio?
Scrip Investment Beta I*B
Dell 25,000 1.20 30,000
FORD 50,000 0.80 40,000
Walmart 25,000 1.00 25,000
Total 100,000   95,000
Portfolio Beta 0.95
The CAPM Model
 The CAPM Model
For a given level of risk as measured by beta, what rate of
return should investors require to compensate them for bearing
that risk?
 Example-2
Assuming that the average return of the market is 11% and the risk-free
rate is 6%. Calculate the required return of stock i that has a Beta of 0.5.
Solution:
= +()
= +()
= +()
=8.5%
 Example-2
Calculate the required return of stock j which is riskier with a Beta of 2.0
= +()
= +()
=
Calculate the required return of an average stock which has a beta of 1.0
= +()
= +()
=
Assumptions of CAPM
 Efficient Portfolio
Efficient portfolios, defined as those portfolios that provide the highest expected return for any
degree of risk, or the lowest degree of risk for any expected return
Two asset case
 Example-3
Expected return of A = 5% and a standard deviation of returns for A is 4%,
while Expected return of B is 8% and standard deviation of B is 10%.
Assume Wa is 0.75 and correlation between A and B is 0. What is the
return and risk of the portfolio?