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Topics Covered Measuring Market Risk Beta Risk and Return CAPM Capital Budgeting and Project Risk Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market. *Only “macro” events affect the value of the market portfolio. Beta - Sensitivity of a stock’s return to the return on the market portfolio. *A measure of a stock’s risk relative to the risk of the market portfolio. Measuring Market Risk Example - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information. Measuring Market Risk Example - continued Measuring Market Risk When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. Measuring Market Risk Example - continued Measuring Market Risk Beta is the slope of the regression line of the individual stock returns relative to the market portfolio returns. If the slope indicates a change in historical stock returns similar to the market, the beta has a value of 1. Defensive stocks historically tend to vary less than the market portfolio; aggressive stocks have a history of more variation relative to the market portfolio. Measuring Market Risk Measuring Market Risk Any stock’s return is comprised of two parts. The first is explained by the macro events that affect the overall market. The second part of the return is related to the firm-specific events that affect the firm but do not the overall market. Stock Betas Portfolio Betas Diversification decreases variability from unique risk, but not from market risk. The beta of your portfolio will be an weighted average of the betas of the securities in the portfolio. If you owned all of the SP