BETA & CAPM

FINANCIAL MARKETS
TWO MAJOR TYPES OF RISK

 FIRM SPECIFIC
 SYSTEMATIC OR MARKET RISK
CONCLUSION

The risk premium for diversifiable risk

is zero, so investors are not
compensated for holding firm-specific
risk.
CONCLUSION

The risk premium of a security is

determined by its systematic risk and
does not depend on its diversifiable
risk.
 MEASURING SYSTEMATIC RISK

 Tomeasure the systematic risk of a stock, we must

determine how much of the variability of its return is due
to systematic, market-wide risks versus diversifiable,
firm-specific risks.
 That is, we would like to know how sensitive the stock is
to systematic shocks that affect the economy as a whole.
MEASURING SYSTEMATIC RISK

 Thus, the first step to measuring systematic risk is finding a portfolio

that contains only systematic risk. Changes in the price of this
portfolio will correspond to systematic shocks to the economy.
 We call such a portfolio an efficient portfolio. An efficient portfolio
cannot be diversified further—that is, there is no way to reduce the
risk of the portfolio without lowering its expected return. How can
we identify such a portfolio?
MEASURING SYSTEMATIC RISK

 Because diversification improves with the number of stocks

held in a portfolio, an efficient portfolio should be a large
portfolio containing many different stocks. Thus, a natural
candidate for an efficient portfolio isthe market portfolio
MEASURING SYSTEMATIC RISK

 Because it is difficult to find data for the returns of many

bonds and small stocks, it is common in practice to use the
S&P 500 portfolio as an approximation for the market
portfolio, under the assumption that the S&P 500 is large
enough to be essentially fully diversified.
SENSITIVITY TO SYSTEMATIC RISK
 If we assume that the market portfolio (or the S&P 500) is efficient, then
changes in the value of the market portfolio represent systematic shocks
to the economy. We can then measure the systematic risk of a security
by calculating the sensitivity of the security’s return to the return of the
market portfolio, known as the beta (b) of the security. More precisely,

 The beta of a security is the expected % change in its return given a 1%

change in the return of the market portfolio.
SAMPLE
 Market efficiency refers to the degree to which market prices
reflect all available, relevant information. If markets are
efficient, then all information is already incorporated into prices,
and so there is no way to "beat" the market because there are no
undervalued or overvalued securities available.
ARBITRAGE PRICING THEORY
EXAMPLE OF USE
CAPM VS. APT
SEATWORK