FNAN 405: Ch. 12

SML formula:

(E(Rm) - Rf)/Bm = (E(Rm) - Rf)/1 = E(Rm) - Rf where E(Rm)-Rf is the market risk premium bc it is the risk premium on a market portfolio.

CAPM states that the expected return for an asset depends on 3 things:

1. the pure time value of money 2. the reward for bearing systematic risk 3. the amount of systematic risk

Security market line (SML)

A graphical representation of the linear relationship btwn systematic risk and expected return in financial markets.

CAPM

A theory of risk and return for securities in a competitive capital market.

Diversification and risk:

Diversification essentially eliminates unsystematic risk, so a portfolio with many assets generally has almost no unsystematic risk.

CAPM formula:

E(R) = Rf + Beta (Rm-Rf)

The amount of systematic risk

Is measured by Beta, which is the amount of systematic risk present in a particular asset relative to that in an average asset.

The reward for bearing systematic risk

Is measured by the market risk premium, E(Rm) - Rf, which is the reward the market offers for bearing an average amount of systematic risk.

The pure time value of money

Is measured by the risk-free rate, Rf, which is the reward for merely waiting for your money, without taking any risk.

Beta coefficient

Measure of the relative systematic risk of an asset. Assets with betas larger than 1.0 have more systematic risk than average. Assets with betas smaller than 1.0 have less systematic risk than average. -Bc assets with larger betas have greater systematic risks, they will have greater expected returns.

What determines the size of the risk premium on a risky asset?

Systematic risk

Normal or expected return

The part of the return that investors predict or expect; depends on the info investors have about the stock.

Uncertain or unexpected return

The part of the return that is uncertain or risky; portion that comes from unexpected information revealed during the year.

Systematic risk principle:

The reward for bearing risk depends only on the systematic risk of an investment; the expected return on an asset depends only on its systematic risk. No matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and risk premium) on the asset.

Reward to risk ratio

The reward to risk ratio must be the same for all assets in a competitive financial market. [(E(Ra) - Rf)/Ba] = [(E(Rb) - Rf)/Bb]

Systematic risk

The risk that influences a large number of assets; called market risk and non-diversifiable risk.

Unsystematic risk

The risk that influences a single company or a small group of companies; called unique risk or firm-specific risk and diversifiable risk.

Formula for total return:

Total Return = Expected Return + Unexpected Return

Formula for total risk:

Total risk = Systematic risk + Unsystematic risk

Formula for unexpected return:

Unexpected Return = Total Return - Expected Return