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Unit 11: Capital Market Theory




                                      = Standard deviation of returns of individual security    Notes
                                     i
                                      = Standard deviation of returns of market portfolio
                                     m

                         What is beta co-efficient?
             Did u know?
             A beta coefficient is a relative measure of the sensitivity of an assets’ return to changes in
             the return on the market portfolio. Mathematically, the beta coefficient of a security is the
             security’s covariance  with the market portfolio divided by  the variance  of the market
             portfolio. The beta factor is the measure of volatility of systematic risk of a security or
             investment in the portfolio. The beta factor of the market as a whole is 1.0. A beta of 1.0
             indicates average level of risk while more or less than that the security’s return fluctuates
             more or less than that of  market portfolio.  A zero  beta means  no risk. The degree of
             volatility is expressed as follows:
             1.  If the beta is one, then it has the same risk profile as the market as a whole, the
                 average risk profile.
             2.  If the beta is less than one, it is not as sensitive to systematic or market risk as the
                 average  investment.

             3.  If beta is more than one, it is more sensitive to the market or systematic risk than the
                 average  investment.

          11.6 Beta Factor of a Market Portfolio

          If the return from the market portfolio rises or falls, we should expect a corresponding rise or
          fall in the return from an individual share. The amount of this corresponding rise or fall depends
          on the beta factor  of the  share. The beta factor of an  investor’s portfolio  is the  total of  the
          weighted average beta factors of each security in the portfolio. As the market portfolio represents
          all shares on the stock market, it follows that the beta coefficient of the market portfolio must be
          1, and all other betas are viewed  relative to  this value.  Thus, if the return from the market
          portfolio rise by says 2%, the coefficient would be:

                                Increase in return on investment  2%
                                                                  1
                              Increase in return on market portfolio  2%
          CAPM indicates the expected return of a particular security in view of its systematic or market
          risk. The value of a share price is determined in relation to investment in shares of individual
          companies, rather than as a portfolio.
          In practice, for estimation of beta factor the following regression equation is used:
              R  =    +   R  + e
               i    i  i   m  i
          Where,
              R = Rate of return of individual security
               i
                = The intercept that equals the risk free rate (R )
               i                                       f
                = Beta factor of he individual security
               i
              R = Market of return
               m
              e = Random error, which reflects the diversifiable risk of individual security
               i





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