Beta and CAPM

Lecture 4, FM 2.2

The Historical Tradeoff

Between Risk and Return
Excess Returns
The difference between the average return for an
investment and the average return for risk-free
investment (DTS, T-bills,)

Risk-Free Rate
Determining the Risk-Free Rate
The yield on U.S. Treasury securities or
government bonds in the country of the
project/company (DTC in The Netherlands)
LIBOR (ended up in tears )
Currently: overnight swap rate

Volatility Versus Excess Return of U.S. Small Stocks, Large Stocks

(S&P 500), Corporate Bonds, and Treasury Bills, 19262008

The Historical Tradeoff Between Risk and Return in Large

Portfolios, 19262005

Source: CRSP, Morgan Stanley Capital International

The Returns of Individual Stocks

Is there a positive relationship between
volatility and average returns also for
individual stocks?
As shown on the next slide, there is no precise
relationship between volatility and average return
for individual stocks.
Larger stocks tend to have lower volatility than
smaller stocks.
All stocks tend to have higher risk and lower returns
than large portfolios.

Historical Volatility and Return for 500 Individual Stocks,

by Size, Updated Quarterly, 19262005

Common Versus Independent Risk

Common Risk
Risk that is perfectly correlated
Risk that affects all securities

Independent Risk
Risk that is uncorrelated
Risk that affects a particular security

Diversification
The averaging out of independent risks in a
large portfolio

Diversification
in Stock Portfolios (cont'd)
Firm-Specific Versus Systematic Risk
Independent Risks
Due to firm-specific news
Also known as:
Firm-Specific Risk
Idiosyncratic Risk
Unique Risk

Unsystematic Risk
Diversifiable Risk

Diversification
in Stock Portfolios (cont'd)
Firm-Specific Versus Systematic Risk
Common Risks
Due to market-wide news
Also known as:
Systematic Risk
Undiversifiable Risk
Market Risk

Diversification
in Stock Portfolios (cont'd)
Firm-Specific Versus Systematic Risk
When many stocks are combined in a large
portfolio, the firm-specific risks for each stock will
average out and be diversified.
The systematic risk, however, will affect all firms
and will not be diversified.

No Arbitrage and the Risk Premium

The risk premium for diversifiable risk is zero,
so investors are not compensated for holding
firm-specific risk.
The risk premium of a security is determined
by its systematic risk and does not depend on
its diversifiable risk.

No Arbitrage
and the Risk Premium (cont'd)
A stocks volatility, which is a measure of total risk
(systematic risk plus diversifiable risk), is not an
appropriate measure of risk for an individual
security. (It is for portfolios).

There is no clear relationship between volatility

and average returns for individual securities.
To estimate a securitys expected return, we need
to find a measure of a securitys systematic risk.

Measuring Systematic Risk

To measure the systematic risk of a stock, we
need to determine how much of the variability
of its return is due to systematic risk vs
idiosyncratic risk.
How to do that? Concept of beta

Market Portfolio
An (idealized) portfolio that contains all shares and
securities in the market
The S&P 500 (500 biggest stocks in US) is often used as a
proxy for the market portfolio in the US.

AEX in The Netherlands

MSCI World Index: for the whole developed world (>1600
stocks)
Most of these indices are value-weighted (according to
stocks market capitalization)
Some of them are price-weighted (DJIA)

Concept of Beta
Diversified portfolio: only MARKET RISK
Contribution of an individual asset to portfolio risk is NO LONGER related to
its volatility
it is related to how sensitive an asset is to market movements.

This sensitivity is called beta of an asset

Interpretation: On average, if the market moves by 1%, the asset price will
move by beta%. ON AVERAGE!
Bottom line: In a diversified portfolio context, risk of an asset is measured
by its beta!

Definition of Beta

Sensitivity to Systematic Risk: Beta ()

The expected percent change in the excess return of a security for a 1%
change in the excess return of the market portfolio.

Beta differs from volatility. Volatility measures total risk (systematic plus
unsystematic risk), while beta is a measure of only systematic risk.
Beta of asset i is defined as

Cov(market, i )

2
market

where Cov(market, i) is the covariance between asset is return and market

2
return, and market
is the variance of the market return.

Another way of calculating Beta:

The beta is calculated as:
Volatility of i that is common with the market

Mkt
i

SD(Ri ) Corr (Ri ,RMkt )

SD(RMkt )

Cov(Ri ,RMkt )

Var (RMkt )

Trivial examples
What is beta of a risk-free asset?
What is beta of the market portfolio?
What is beta of a portfolio consisting for x% of
market portfolio and (1-x)% of risk free asset?

Linear regression for calculating beta

Monthly Returns for Cisco Stock and for the S&P 500, 19962009

Scatterplot of Monthly Excess Returns for Cisco Versus the

S&P 500, 19962009

Estimating Beta from Historical

Returns
Beta corresponds to the slope of the best-fitting
line in the plot of the securitys excess returns
versus the market excess return.

Using Linear Regression

Linear Regression:
(Ri rf ) i i (RMkt rf ) i
i is the intercept term
i represents the sensitivity of the stock to
market risk. When the markets return increases by 1%,
the securitys return increases by i%
i is the error term and represents the deviation from the
best-fitting line and is zero on average.

Using Linear Regression

Given data for rf , Ri , and RMkt , statistical

packages for linear regression can estimate i.

A regression for Cisco using the monthly returns for
19962009 indicates the estimated beta is 1.80.
The estimate of Ciscos alpha from the regression is
1.2%.

Practical Considerations When

Forecasting Beta
1. Time Horizon
For stocks, common practice is to use at least two
years of weekly return data or five years of
monthly return data.

2. The Market Proxy

In practice the S&P 500 is used as the US market
proxy. Other proxies include the MSCI World or
regional indices (FTSE, AEX, DAX, ).

Practical Considerations When

Forecasting Beta
3. Beta Variation and Extrapolation
Betas vary over time, so many practitioners prefer
to use average industry betas rather than
individual stock betas.
In addition, evidence suggests that betas tend to
regress toward the average beta of 1.0 over time.

Estimated Betas for Cisco Systems,

19992009

Practical Considerations When

Forecasting Beta
Beta Extrapolation
Adjusted Betas

2
1
Adjusted Beta of Security i
i (1.0)
3
3

Estimation Methodologies Used by Selected Data

Providers

Betas with Respect to the

S&P 500 for Individual
Stocks (based on
monthly data for 2004
2008)

Practical Considerations When

Forecasting Beta
4. Outliers
The beta estimates obtained from linear
regression can be very sensitive to outliers, which
are returns of unusually large magnitude.

Beta Estimation with and without Outliers for Genentech

Using Monthly Returns for 20022004

Determining the Risk Premium

Capital Asset Pricing Model (CAPM):
Given a market portfolio, the expected return of
an investment is:
E[Ri ] ri rf iMkt (E[RMkt ] rf )
Risk premium for security i

Example
Assume the risk-free return is 5% and the
market portfolio has an expected return of
12% and a volatility of 44%.
ATP Oil and Gas has a volatility of 68% and a
correlation with the market of 0.91.
What is ATPs beta with the market?
Under the CAPM assumptions, what is its
expected return?

 Solution
SD(Ri ) Corr (Ri ,RMkt ) (.68)(.91)
i

1.41
SD(RMkt )
.44

E[Ri ] rf iMkt (E[RMkt ] rf ) 5% 1.41(12% 5%) 14.87%

The Security Market Line

CAPM says that there is a linear relationship between a stocks beta and its
expected return:

E[Ri ] ri rf iMkt (E[RMkt ] rf )

Risk premium for security i

This is the equation for the so-called security market line (SML).

According to the CAPM, if the expected return and beta for individual
securities are plotted, they should all fall along the SML. They dont!

The Security Market Line

The SML shows the
expected return for each
security as a function of
its beta with the market.
According to the CAPM,
all stocks and portfolios
should lie on the SML.
In reality: low-beta
stocks perform better
than CAPM predicts;
high-beta stocks perform
worse than CAPM
predicts.

What about reality?

Do all stocks lie on SML?

Testing CAPM: plot estimates of betas versus average premium on an asset (average return
risk-free return)

Turns out that: high-beta assets generate lower returns than predicted by CAPM and lowbeta assets generated higher returns.

Also: some zero-beta assets (e.g. catastrophe bonds) offer returns higher than risk-free rate
of return !

Why? CAPM has many assumptions: does not take into account borrowing, behavioral
aspects, no default by the state, etc etc etc

Beta is not estimated very well for a single company

NO!

 Identifying a Stocks Alpha

To improve the performance of their portfolios,
investors will compare the expected (or historical
average) return of a security with its required
return from the security market line.
rs rf s (E[RMkt ] rf )

 Identifying a Stocks Alpha

The difference between a stocks expected return
and its required return according to the security
market line is called the stocks alpha.

s E[Rs ] rs
If the market portfolio was efficient, all stocks
would be on the security market line and have an
alpha of zero.

Deviations from the Security Market Line

We can also define beta of a portfolio (instead of individual

asset) and use CAPM to estimate the required return on it.
The beta of a portfolio is the weighted average beta of the
securities in the portfolio:

Cov i xi Ri ,RMkt
Cov(RP ,RMkt )

Var (RMkt )
Var (RMkt )

i xi

Cov(Ri ,RMkt )

Var (RMkt )

x
i

Example
Problem
Suppose the stock of the 3M Company (MMM)
has a beta of 0.69 and the beta of HewlettPackard Co. (HPQ) stock is 1.77.
Assume the risk-free interest rate is 5% and the
expected return of the market portfolio is 12%.
What is the expected return of a portfolio of 40%
of 3M stock and 60% Hewlett-Packard stock,
according to the CAPM?

Example (contd)
Solution

P i xi i (.40)(0.69) (.60)(1.77) 1.338

E[Ri ] rf

Mkt
i

(E[RPortfolio ] rf )

E[Ri ] 5% 1.338(12% 5%) 14.37%

Summary of the Capital Asset

Pricing Model
The expected return on any security is
proportional to beta and is given by:

E[Ri ] ri rf iMkt (E[RMkt ] rf )

Risk premium for security i