Class 11: CAPM Flashcards
What’s Beta?
Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. It represents the asset’s sensitivity to the market portfolio.
It’s the slope of the regression on the return of the stock and the market return.
How do you calculate Beta?
You run a regression of the stock’s historical returns on the market’s historical returns and the result slope of that line is beta. It’s the amount of market risk, your exposure/sensitivity to the market.
What happens when the beta is negative?
A negative beta would mean that when market goes up your stock goes down, when the market goes down, your stock goes up. It’s called a counter-cyclical asset, something that moves against the market. Example: bonds, staple goods, things that do well in bad times
What’s the beta of the market portfolio?
Beta of market portfolio = 1
What’s the beta of the the risk-free asset?
Beta of the the risk-free asset = 0
What’s the beta of a pro-cyclical asset?
Beta of a pro-cyclical asset >1
This means that it moves with the market but exponentially
What’s the beta of a counter-cyclical asset?
What’s the beta of a counter-cyclical asset <0
What’s the formula/model for the discount rate?
If the market rate is 10% in expectation and Tesla’s Beta is 2, what would be an approximate discount rate for Tesla? Why?
Tesla discount rate would be around 20% because it is double the risk (10% market risk * 2). Because it has a highly recession risk, it’s twice as risky as the market.
If the market rate is 10% in expectation and Walmart’s Beta is 0.5, what would be an approximate discount rate for Walmart? Why?
Walmart’s discount rate would be around 5% because it is half the risk (10% market risk÷2). Because it has a lower recession risk, it’s half as risky as the market, Walmart does better in bad times.
What’s the CAPM and what does it measure?
CAPM= Expected Return = Cost of Capital
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets. It tells us what the expected return is related to the security/stock’s beta.
It only depends on covariance (market risk) not standard deviation (unique risk)
How do you calculate the CAPM / Expected Return?
E[ri]= rf + βi×(E[rM]-rf)
Can a company have more than one beta?
Yes! For example, a company with many divisions may have a different beta for each division. For example, Amazon 1)Retail & 2)Cloud services
The beta of the portfolio is the weighted average of the individual betas:
βp= W1β1 + W2β2 +…WNβN
