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Understanding Risk: Security Market Line & Beta Coefficient, Exams of Security Analysis

The concepts of systematic and unsystematic risk in finance, with a focus on the Security Market Line and the Beta Coefficient. It discusses how these concepts are used to measure and compare the risk and expected return of different investments. The document also touches upon the Capital Asset Pricing Model (CAPM) and the sources of beta estimates.

What you will learn

  • How is systematic risk measured using the Beta Coefficient?
  • What is the difference between systematic and unsystematic risk?
  • What is the Security Market Line and how is it related to the CAPM?

Typology: Exams

2021/2022

Uploaded on 09/27/2022

bartolix
bartolix 🇬🇧

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Return, Risk and the Security
Market Line
Systematic and Unsystematic
Risk
Systematic risk
Risk that influences a large number of
assets. Also called market risk.
Unsystematic risk
Risk that influences a single company or
a small group of companies. Also called
unique or asset-specific risk.
Total risk = Systematic risk + Unsystematic risk
Diversification and Risk
In a large portfolio, some stocks will go up in
value because of positive company-specific
events, while others will go down in value
because of negative company-specific events.
Unsystematic risk is essentially eliminated by
diversification, so a portfolio with many assets
has almost no unsystematic risk.
Unsystematic risk is also called diversifiable risk,
while systematic risk is also called
nondiversifiable risk.
The Systematic Risk Principle
The systematic risk principle states that
the reward for bearing risk depends only
on the systematic risk of an investment.
So, no matter how much total risk an asset
has, only the systematic portion is relevant
in determining the expected return (and
the risk premium) on that asset.
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Return, Risk and the Security

Market Line

Systematic and Unsystematic

Risk

Systematic risk Risk that influences a large number of assets. Also called market risk. Unsystematic risk Risk that influences a single company or a small group of companies. Also called unique or asset-specific risk.

Total risk = Systematic risk + Unsystematic risk

Diversification and Risk

  • In a large portfolio, some stocks will go up in value because of positive company-specific events, while others will go down in value because of negative company-specific events.
  • Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.
  • Unsystematic risk is also called diversifiable risk, while systematic risk is also called nondiversifiable risk.

The Systematic Risk Principle

  • The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment.
  • So, no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

Measuring Systematic Risk

Beta coefficient ( β ) Measure of the relative systematic risk of an asset. Assets with betas larger than 1. have more systematic risk than average, and vice versa.

  • Because assets with larger betas have greater systematic risks, they will have greater expected returns.
  • Note that not all betas are created equal.

Measuring Systematic Risk

Portfolio Betas

  • The standard deviation of a portfolio has no simple relation to the standard deviation of the assets in the portfolio.
  • In contrast, a portfolio beta can be calculated just like the expected return of a portfolio. - In general, you can multiply each asset’s beta by its portfolio weight and then add the results to get the portfolio’s beta.

The Reward-to-Risk Ratio

  • Notice that all the combinations of portfolio expected returns and betas fall on a straight line.
  • Slope
  • What this tells us is that asset A offers a reward-to-risk ratio of 7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk.
  1. 50 %
  2. 6

20 % 8 % β

= − =

A

ERA Rf

Capital asset pricing model (CAPM) A theory of risk and return for securities on a competitive capital market.

The Security Market Line

  • The CAPM shows that E(Ri ) depends on c Rf , the pure time value of money. d E(R (^) M) – Rf , the reward for bearing systematic risk. e β i , the amount of systematic risk.

E ( Ri ) = Rf +[ E ( RM )− Rf ] ×β i

The Security Market Line

Where Do Betas Come From?

  • A security’s beta depends on

c how closely correlated the security’s return is with the overall market’s return, and d how volatile the security is relative to the market.

  • A security’s beta is equal to the correlation multiplied by the ratio of the standard deviations.

m

i i Ri^ RM σ

σ β =Corr , ×

Why Do Betas Differ?

  • Betas are estimated from actual data. Different sources estimate differently, possibly using different data. - For data, the most common choices are three to five years of monthly data, or a single year of weekly data. - To measure the overall market, the S&P 500 stock market index is commonly used. - The calculated betas may be adjusted for various statistical reasons.

The investment process

The Investment Process

  • Specify objectives
  • Identify constraints (investment horizon, regulations, tax considerations, unique needs)
  • Formulate an investment policy (active, passive, or some mix of active and passive)
  • Monitor performance
  • Reevaluate and modify portfolio as determined from monitoring

The Investment Process

  • Asset Allocation—allocation of an investment portfolio across broad asset classes
  • Security Selection—choice of specific securities within each asset class
  • Security Analysis—analysis of the value of the securities