ADMS 3530 Winter 2012 – Professor Lois King
Lecture 10 – Risk, Return and Capital Budgeting – Mar 13
10.1 Total Risk, Unique Risk & Market Risk
− Recall from Unit 9 – Total risk can be broken into two parts:
o Total risk – measured by Variance or Standard Deviation.
Unique or Unsystematic Risk
• Can be diversified away.
• Caused by factors within a company’s operations (debt levels,
dividend yield, firm size, etc.)
Market or Systematic Risk
• Nondiversifiable risk.
• Caused by macroeconomic factors (inflation, interest rates, GDP
− How can we calculate the level of Market Risk for a security?
o First, we need a market portfolio.
In theory, the market portfolio is comprised of all risky assets that exist in
the world economy, such as stocks, bonds, commodities, real estate, etc.
In practice, analysts use a large equity index, such as the S & P 500, as a
o Beta of a stock – measures the sensitivity of a stock’s return to the return on the
10.2 Measuring Market Risk
− Beta is a measure of market risk.
o The sensitivity of a stock’s returns to fluctuations in returns on the market.
o A measure of a stock’s exposure to changes in macroeconomic factors.
− How do you calculate the beta of a stock or a portfolio (from raw data)?
o Plot a chart of the returns of the market portfolio against the returns of stock ‘j’.
o Then find the line of ‘best fit’ (or what is known as the regression line);
o The slope of the line can be found by ordinary least squares regression
o This slope is called a stock’s beta – Bj.
− Market portfolio – Beta = 1.0
− Aggressive Stocks – Beta > 1.0 (e.g. four seasons, ford)
− Treasury Bills – Beta = 0 (riskfree asset) − Defensive stocks – Beta