Total risk can be separated into systematic and unsystematic risk. Systematic risk cannot be eliminated through diversification while unsystematic risk can be reduced. Beta measures the amount of systematic risk an asset has relative to the market. The Capital Asset Pricing Model calculates the expected return of an asset as equal to the risk-free rate plus the product of the asset's beta and the market risk premium. It accounts for the risk-free rate, market risk premium, and the asset's systematic risk as measured by its beta.

1. Risk, Return, and
the Capital Asset Pricing Model
Dr. SAYYAD SAADIQ ALI

2. RISK
Total Risk = Systematic + Unsystematic Risk
Systematic Risk is also called Nondiversifiable
Risk or Market Risk
Unsystematic Risk is also called Diversifiable
Risk or Unique Risk

3. Diversification
Can eliminate some risk
Unsystematic risk tends to disappear in a
large portfolio
Systematic risk never disappears

4. Beta
Beta = How much systematic risk a
particular asset has relative to an average
asset
For example:
XOM: 0.65
VIAB: 1.22
YHOO: 3.56
MII Portfolio: 1.54

5. Capital Asset Pricing Model
Er = Rf + B{E(Rm)-Rf}
Works for both individual assets
and portfolios

6. McIntire Investment Institute
Example:
If Rf = 5.5%
Market Risk Premium = 7%
Then the MII should return:
Er = 5.5% + 1.54(12.5%-5.5%)
Er = 16.28%

7. Expected Return depends on
3 things
The time value of money (risk-free rate, Rf)
The reward for bearing systematic risk
(market risk premium={E(Rm) - Rf}
The amount of systematic risk (Beta)