 Hello and welcome to this session. This is Professor Farhad and which would look at an examples that illustrate the single index stock market model, specifically interpreted in a regression line. This topic is covered on the CFA as well as the CPA exam because on the CPA exam, you will need to know how to read your regression line. It's also covered in an essentials of investment scores, whether graduate or undergraduate. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. Connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to complement and supplement this course as well as your accounting, finance, CPA exam and other professional certification. So in this session, we're going to try to interpret the eight scattered diagram in terms of systematic risk, diversifiable risk and the intercept. So we're going to look at each one of them and just look at the, let's look at their systematic risk. Now what is systematic risk? Basically systematic risk is the market risk and it's, it is shown as beta. It's shown as beta in our regression formula. So let's take a look at those and what can we say about beta? What can we say about the, the systematic risk for these graphs? So let's take a look at them. First, you want to make sure you know how to, what are you looking for? You're looking at the x-axis and you're looking at the y-axis. On the x-axis, we have the market return. Let's assume the S&P 500 and on the x, on the y-axis, we have the individual stock return, whatever that stock is. And now we're computing the beta. Now, before we compute the beta, let me go back to the prior session and show you the beta. When we talked about the beta, we said a beta of one. If you remember when we talked about the beta, we said a beta of one. It means that's the market beta. Then I showed you two other betas. I showed you the beta for Amazon and I told you Amazon has a beta of 1.33. 1.33 means, and this was a five-year monthly data. 1.33, it means Amazon moves for every 1% that the market moves, it moves 1.33. That's the beta for Amazon. The beta for a company like Walmart is 0.32. Well, it means it moves less. Actually, it moves less than one. So we'd say Walmart is a defensive stock and Amazon is an aggressive stock. But now in relationship to the market, which has a beta of one. So one has one above one and one below one. So let's take a look at this graph to see how we interpret these betas. So how do we interpret the beta? So the steeper the line, the larger is the beta. But let's take a look at whether the beta is positive or negative. Well, if we notice here, this line right here for R1, if we look at R1 graph, we notice as the market rate goes up, as the market rate goes up, the stock price goes up. It means they are positive relationship. Same thing with R2, positive relationship. R3, positive relationship. It means beta is positive, positive, positive, positive. Now if we go to R7, we notice that beta is negative. What does that mean? It means there's a negative relationship between the market and this price. It's not positive, it's negative. Now, how else can we talk about the beta? So whether it's positive or negative. We want to know how large is the beta. How do we know how large is the beta by looking at the graph? Well, the steeper is the graph, I'm sorry, not the graph. The steeper is the line, the larger is the beta. So what do I mean by the steeper is the line? Let's take a look at R1 versus R4, just to illustrate the point. What do we say between R1 and R4? Look, let's assume this is 1, 2, 3, 4, and this is 1, 2, 3, 4. So as the market moves one point, this moves too. As the market moves, it moves higher. As the market moves, it moves higher. Notice here, if this is 1, 2, 3, 4, notice where they meet. Now, the stock does not move faster than the market. It means they move in tandem, so beta is lower. So when the line is steeper, notice here in R1, is the line a steeper, it means the stock moves faster than the market. Notice there is a big gap versus a small gap. So the steeper this line, so if this line was this much steeper, it moves way faster than the market. So as the market moves one point, if it moves this steep, the other move will be here. The stock market, the stock price moves faster. It has a high beta. So what we can say is this. If we notice 1, I would say 2 is a steep, 3 is not as much, and 6 is steep. So we'd say 1, 2, and 3, they have a larger beta. Larger beta means more systematic risk. There is more market risk. If we can see that R3, let's change the color, R3, 4, and 5, they're flatter. What does that mean? It means beta is not high. It means they are defensive stock. In a sense, they are defensive stock. Okay? When the market moves, they don't move as fast as the market. The beta is less than 1. If you move exactly like the market, you'll be 1. If you move less, you are considered defensive, defensive stock. And how do you know you're a defensive stock? Your line is a little bit flat, just like R5. So this is the beta. This is the systematic risk. By looking at this, you need to understand how we interpret this. Now let's take a look at alpha. So we looked at beta. Let's look at alpha since we're going to go. We should have started with alpha, then beta, but it doesn't matter. Alpha is the intercept. What is the intercept? Is where the line hits the y-axis. Is where the line hits the y-axis. Where does the line hits the y-axis? Let's look at this. The line hits the y-axis here. The line hits the y-axis here, here, here, here, here, and here. This is the intercept of the line. What is the intercept of the line? what is the expected return when the market is neutral? When you have no risk premium in the market, what do you expect to earn? When there is no risk premium, what do you expect to earn? Now, even if there is no risk premium, you want to expect positive. You want to have a positive y-intercept. So here, y-intercept is positive. Here, y-intercept is negative. Positive. I'm sorry, negative here for R3. Positive. Negative. Negative. Negative. And positive. So you want the y-intercept to be positive. Now, why? If you remember the regression line formula, it's alpha plus beta times the risk premium plus the EI, the risk that's specific to the firm. So this is the line. This is the regression line. So you want this to be plus to have a higher return. You want alpha to be plus. So that's why. So the y-intercept, the intercept is alpha is where the regression line crosses the y-axis. And you want to cross the y-axis on the positive and not negative end. So that's the intercept. Let's take a look at the diversifiable risk. So what can we tell from these graphs about what we call the diversifiable risk? What is the diversifiable risk? Is the risk that you can get rid of by diversifying. Well, how do you know if you can get rid of the risk by diversifying? The more the points are clustered to the line. So notice here, those points are clustered to the line, to the single line. It means the risk can be diversified. The risk if we have enough stocks, if we combine them all together, we can diversify the risk. We can diversify the risk. So let's take a look at R2 right here. I would say R3 and R7. R7. So what can we say about those? They have a low residual value. They have a low residual value. Why? Because notice the performance of the stock is close to the line. The closer it is, the low is the residual value. If we look at other stocks like R4, let's see if there's one that's worse. Let's look at R1. Notice R1, the points, the return are a little bit further from the line. Notice R8, same thing. There's a lot of residual value. Residual value means there's a lot of risk that's specific to the company. That's specific to the company. For R2, R3 and R7, the more we diversify, the closer we're going to get to the line. Why? Because the return of the stock is affected mainly by the market, not by the residual value, not by the firm specific. This is what we can say. So what can we say overall about the total variance just from the graph? What can we say? Well, let's take a look at each one separately. Let's take a look at each one separately. If we look at R1, if we look at R1, R1 and R6 are very similar. If we look at R1 and R6, they look very similar. Positive, positive beta, obviously positive, and it's a high beta. High beta, one has a Y-intercept. One has a positive Y-intercept. One is negative and one is positive. That's fine. They both have a high beta and notice they both have a high residual value. High beta and high residual value. What does that mean? If you have high beta and high residual value, if you have both, it means you have high beta and your risk is not diversifiable. What does that mean? It means you have total variance that's high because the variance is based on your company, your company risk and the market risk. Here, both your company risk is high and the market risk is high. So one and six is kind of basically driskiest. One and six are driskiest because they have both. High beta, the line is steep and the returns are varied across. So that's one and six. Let's look at three. Three I will have to say definitely residual value is low. Residual value is low. Notice the points are scattered closer to the line and it's not that steep. It's not as steep. It's steep, but it's not as steep. I would say it's not bad from terms of variability. We have a low beta. Now let's say two. Let's see. Now if I'll have to say I would say three will have a low beta. Three will have a low beta and low variance. Yes, low residual value over all low variance, low residual value. Three, not two because two, I see two still have a high beta. So let's go back to two. So two, definitely low, low residual value, low residual value, but high beta. Two has a high beta. I misspoke. I just, it looks, yeah, two has a high beta. So one, two, three, four. What can we say about four? Definitely four is a low beta because the line is is kind of, line is flat, but high residual value. And we're going to talk a little bit more about the residual value in the next session when I look more at the regression equation specifically about R square. We'll look at R square. So basically we looked at, we looked at them all. Hopefully this gives you an idea about how to interpret this regression line. So a few things you want to remember. Where does it cross the y-axis? That's the intercept. How steep it is. The steeper it is, the higher is the beta. It means the higher the systematic risk. And how much the points are scattered across tells you about the residual, whether the residual value is high or low. High means they're scattered all over. It means the risk of this company is dependent upon the company itself, not upon market condition, market condition. In the next session, again, maybe I'll work a regression line just kind of to work a little bit more with the formula. As always, I'm going to remind you to connect with me and like this recording, share it. And if you want additional resources about this course, please visit my website. Study hard, stay safe, and good luck.