The total risk to a stock can be divided into two parts. The first is the systematic rate, which is the risk associated with the market and cannot be diversified away. The second is unsystematic risk, which is the risk inherent to the stock and can be eliminated through diversification. Beta is a measure of a systematic risk of a stock. Beta describes the sensitivity of a stock’s returns to the changes in the market. As asset with a beta of zero means its return is independent of changes in the market return.
The Capital Asset Pricing Model calculates the expected return on equity of an individual company. It is based on the expected rate of return on the market, the risk-free rate and the beta coefficient of an individual security or portfolio. There is a basic reward for weighing the risk free rate. The greater the risk, the greater the expected reward. There is always a consistent trade off between the risks and the rewards. In this equation, the following variables are defined as:
Rf= Risk free rate
ERm= Expected rate of return on market
ERm-Rf= The difference between the expected market rate of return and the risk free rate, which is known as the market premium.
The Security Market Line is a graph representation of CAPM formula. It plots the expected return of stocks on the y-axis against the beta on the x-axis. The intercept is the risk free rate and the slope represents the market premium. Individual securities expected…