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 assetFor example:

XOM: 0.65VIAB: 1.22YHOO: 3.56MII 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)