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MARKET PORTFOLIO:

Portfolio of all assets in the economy


Beta:
Sensitivity of stocks return to the return on market portfolio
Measuring Beta:
To measure a stocks beta, the following steps should be followed:
1. Collecting data on the returns on the market portfolio over a specified
time period.
2. Collecting data on the returns on a stock over the same time period.
3. Graphing the returns on the stock against the returns on the market.
4. Drawing a regression line through the points and measuring its slope.
5. The slope of the regression line is the stocks beta.
Estimation of Beta:
Portfolio beta:

11-3
RISK AND RETURN:
Risk means you have the possibility of losing some, or even all, of your original
investment.
In the investing world, risk is the chance that an investment's actual return will be
different than expected.

A common misconception is that higher risk equals greater return. The risk/return
tradeoff tells us that the higher risk gives us the Possibility of higher returns. There
are no guarantees. Just as risk means higher potential returns, it also means higher
potential losses.
Therefore, the investors calculate MARKET RISK PREMIUM which is the difference
between market return and return on risk-free bills.

Market risk premium = rm - rf


Therefore, the investors calculate MARKET RISK PREMIUM which is the
difference between market return and return on risk-free bills.
Market risk premium = rm - rf

Beta measures risk relative to the market, when the payout to an


investor that is greater than the risk-free payout, then it is called RISK
PREMIUM.
RISK PREMIUM = (rm - rf)
Capital Asset Pricing Model (CAPM):
Theory of the relationship between risk and return which holds not
only portfolios of market but for any asset called CAPM. It has a simple
interpretation that expected rate of return demanded by investors
depend on two things :
1) The risk-free rate (rf)
2) Risk premium (depends on and market risk premium)
So,
Expected Return = risk-free rate + risk premium
rj = rf + (rm - rf)
Security Market Line (SML):
The SML is just a
Graphical representation
of the CAPM formula
which shows the
relationship between the
expected rate of return of
a project and its beta. Its
is the standard for
projects acceptance or
rejection.
Capital Budgeting and Project Risk:
Capital budgeting is the process of allocating resources for major
capital, or investment, expenditures. One of the primary goals of
capital budgeting investments is to increase the value of the firm to the
shareholders.
Project risk is an uncertain event or condition that, if it occurs, has an
effect on at least one project objective.
SO, When the company invests the cash, shareholders cannot invest
that cash in the capital markret, the return which they are getting on
keeping invest in the company is called, OPPORTUNITY COST OF
CAPITAL. Financial managers use CAPM to estimate OCOC.