Week 5 Discussion

Capital Asset Pricing Model

If the economy contains a risk-free asset, it is easier to create portfolios. By combining the risk-free asset and the market portfolio in various proportions, you can devise a risk-to-return pattern that provides the highest return for a given level of risk.

One model of the relationship between a risk-free asset and the market return is described by the capital asset pricing model (CAPM). In this model, beta (ß) is the measure of an asset's systematic risk with respect to the market. Beta is a measure of relative risk, because it measures the risk relative to the market portfolio, unlike the standard deviation, which is an absolute measure of risk. Because the value of the beta of the market portfolio is one (1), and the beta of a risk-free asset is zero (0), you can develop beta as a measure of risk relative to the market of assets.

If an asset has a beta of 0.5, its variability of returns is half that of the market portfolio. If the beta of an asset is 1.2, the asset's returns are 20% more volatile than the market. This concept is one of the underpinnings of the CAPM. The CAPM states that the expected return on an asset depends upon its level of systematic risk.

Historical or average return: This is the mathematical average of historical returns.

Expected return: The expected return is the weighted average of the expected returns and their respective probabilities.

Standard deviation as a risk measure: A unit measure of deviation or dispersion from the average return or expected return.

Coef�cient of variation: This measures the risk per unit of return of a security.

Risk return tradeoff: There is a relationship between the risk and return of an asset; higher returns come with more risk but not a guarantee of that return.

Portfolio returns: These are a weighted average of the returns of the stocks and their proportion in the portfolio.

Diversi�cation: This is used to lower the risk of a portfolio by adding securities that are not identical in risk and return.

CAPM: CAPM stands for capital asset pricing model, which is used to estimate the expected return of an asset based on its risk relative to the market (its systematic risk).