Capm, Risk and Beta

Part 1 '' A Measurement of Risk 1.1 Risk 1.2 Capital Asset Pricing Model The estimation of systematic risk (or ‘beta’) is central to the implementation of the capital asset pricing model (CAPM) for researchers and practitioners. Markowitz (1952) argued that investors should be concerned with holding efficient portfolios, that is, a portfolio offering the highest expected return for each level of risk. Sharpe (1964) and Lintner (1965) took Markowitz’s work one step further to develop the CAPM to explain the relationship between systematic risk and expected return in financial markets. The CAPM is denoted by the following equation: The CAPM is used to determine the expected return on any security (E(ri)), which is consistent with the notion that price (or expected return) of a security is derived by its market risk. Investors are only concerned with market risk as it is assumed that rational investors hold a portion of the market portfolio, that is, a well-diversified portfolio. Since systematic risk is the crucial determinant of an asset’ s expected return, we use beta as a way of measuring the level of systematic risk for different investments and is given by the following equation. Beta is calculated by dividing the covariance of the excess returns on the stock and excess returns on the market, divided by the variance of excess returns on the market. Excess returns are returns above or below the risk-free rate. According to the methodology of Frino et al (2006) (all formulae are provided under appendix 1.1), the first step in calculating the beta of a security is to collect historical data and calculate a sequence of excess returns on a stock and excess returns on a market. This is illustrated in appendix 1.1 using weekly stock-price data for Rio Tinto, the All Ordinaries Accumulation Index and 10-yr bond yields. Because bond yields are expressed on an annual basis they must be converted to a weekly rate or return (by simply dividing by 52). Furthermore,