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Financial institution - Essay Example

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The risk free return compensates for the time value aspect of the investment. The remaining part represents the ‘risk premium’ where the market return earned in excess of the risk free rate is…
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Financial institution
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Financial institution

Unlike Mean Variance Portfolio theory the CAPM model rewards for the excess beta or additional risk borne by the investor. Higher the beta higher is the compensation required by the security. As per this model a higher ‘standard deviation’ does not mean a higher return as ‘beta’ is the measure of risk under CAPM and not ‘standard deviation’. In the CAPM world an investor is rewarded for bearing the risk that cannot be diversified. This is referred as ‘systematic risk’ captured by the beta of the stock. An investor is not awarded for bearing any nondiversifiable risk i.e. unsystematic risk captured by the standard deviation of the stock. In other words the investors are rewarded for bearing the risk that cannot be diversified away. This is also referred as ‘market risk’ (Sigman, 2005).
The beta is the sensitivity of stock return to the market return. Higher the beta higher is the risk associated with the stock. Gitman (2006) states that beta is “a measure of non-diversifiable risk” i.e. it measures the return on asset with reference to the market return. Ideally the beta of a stock should be “forward-looking” and measured with respect to the whole market, whereas in practice this is based on historical returns and the stock index acts as a proxy for ‘market return’ (Kürschner, 2008, p. 3).
Suppose the beta of Stock A is 2. In the event of a 10% rise or fall in the market the price of Stock A will rise or fall by 20% respectively. Stocks with a beta of more than one are referred as ‘aggressive stock’ and stocks with a beta of less than one are referred as ‘defensive stock’. One can invest in aggressive stocks in times of market upswings and such stocks must be avoided in times of uncertain market conditions. In short the beta co-efficient of a stock measures the volatility in the return of a stock with respect to the market benchmark.
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