 Hello and welcome to the session. This is Professor Farhad in which we would look at the capital asset pricing model known as CAPM. This topic is covered on the CPABEC section exam as well as the CFA exam, also covered in an Essentials or Principles of Investment course. As always, I'm going to remind you to connect with me only then if you haven't done so, YouTube is where you would need to subscribe. I have 1,800 plus Accounting, Auditing, Tax, Finance, Lectures as well as Excel Tutorial. If you like my lectures, please like them, share them, put them in playlists. If you're listening to this recording, it means you're trying to learn about CAPM, so other people might be doing the same as well. 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 other accounting finance courses, CPA, CFA or CMA exam. I strongly suggest you check out my website. The first thing we're going to talk about today is risk premium of the market portfolio. Risk premium is something that we should be familiar with if you are following my course. If not, I'm going to give you an idea what risk premium is, but we need to know about risk premium. I'm sure you know about the risk return trade-off, and this should be a review and simply put, what is a risk return trade-off? We have risk and we have return. And the more risk we take, the more return we expect. Okay? Sometimes we call it the mean variance. The return is the mean and the risk is the variance. Sometimes we call it the mean variance analysis. It's the same thing. And what is that basic idea? More risk should be compensated with more return. If you're going to take risk, you expect more return. You're not a gambler. Gambler will take risk without expecting any return because you're a gambler. As an investor, for you to take an additional position in asserting equity or bond or any type of an investment, you expect additional return to make that additional risk. So you need to be induced to take more risk, induced with more return. Now, what is the expected return? Let's assume you want to buy a stock or equity because we're going to be assuming our investments is equity stocks. So what is your expected return given the fact that there is a risk return trade-off? Well, the expected return, what you expect to return is you want to at least earn the risk free rate. So when you invest, look, when you invest money, you're going to say, what is my risk-free return? What's my risk-free return? What does that mean? It means what happen if I walk into the bank today and deposit all my money there? How much do I get? If I get 2%, that's a risk-free. So that really does not count. But I need to earn at least 10% because I can earn 10% by doing nothing. So my expected return should be 2% plus I need to be compensated for that additional risk. So I need to be compensated. I need to be rewarded for that risk premium. Now, how do I find the risk premium? We'll talk about this a little bit more depending on what type of company you are dealing with, on what type of product they have, in what country you are investing to. So risk premium depend on many things. So let's assume you want 10% to be compensated for your risk premium. So I want 2% because that's safe and I want 10% premium. I expect to earn 12%. So this is what we mean by the expected return. I'm going to show it to you statistically in a different way. So let's assume the risk-free is 2%. Let's assume if you give your money to Uncle Sam, US Treasury Bill, it will earn you 2%. And let's assume the risk premium is 5%. What is your expected return? If I want to invest in your stock and I expect 5% risk premium and the risk-free is 2%, I expect 7%. What is the risk premium for a market portfolio? Now, let's think from a whole market portfolio perspective because simply put, how do we determine the risk premium? Is it the same? No, it changes. So there's an equilibrium for risk premium. So let's look at it from a statistical perspective. Let's think about this. When investors purchase stocks, so when investors start to buy stocks, what happened to that stock price? That stock price generally rises. Not generally. This is what happened. If somebody buying stocks, the stock price rise. As the stock price rise, what happened is you lower your expecting return and premium. So if you bought the stock today at $12 and people kept buying the stocks and now the stocks jumped to $15. If you buy it at $15, well, you should expect lower return than the people that bought it at $12. Why? Because the stock price already went higher because the stock price rises. So what happened is, so let's assume somebody waited until they bought it for $20, they would expect less premium. And what happened as a result, once it gets at $20, less people will start to buy it. As a result, when less people, when they happen, risk premium falls. As the stock price goes up, sorry, as the stock price goes up, you lower the expected return and the risk premium will start to fall. Simply put, you are not rewarded as much anymore because you are buying the stock at a higher price. So what you do then, so when your risk premium falls, what you do is you will take your money and you will switch your money to a risk-free asset. Why? Because it's not worth taking the additional premium. So this is what happened. So notice, so simply put, risk, it's going to go up, then at some point it will go down, then it will go down, then it's then when the stocks are cheap, it will go up again, so on and so forth. So there's an equilibrium. So there's always, it's going to go up and down, that's going to be someplace there's going to be an equilibrium. The risk premium, an equilibrium, the risk premium on the market portfolio must be high enough to induce investors to hold the available supply of stocks. So what happened is you only buy the stock if you have enough risk premium. Of course, we talked about this. If the risk premium is too high, there will be excess demand for securities. Of course, if your risk premium is very high, we want to buy the stock. The stock will start to rise. If it's too low, investors will not hold. If the risk premium is low, if you're not being rewarded, investors will not hold enough stocks to absorb the supply and the prices will fall. So this is what we talked about here. So it will go up, then it will come down. So the equilibrium risk premium of the market is proportional to both the risk of the market measured as the variance of the return. So what's happening to the return? What's happening to the variance of the return? It's going to fluctuate and based on the risk premium will change and the degree of risk aversion of the average investors. If the investors are risk tolerant, they're going to buy the stock. It doesn't matter whether it's going to go to 20 or 25 or 30. I can tell you, for example, Tesla people. Tesla people means Tesla that invest in stocks. I call them Tesla people because they believe in the company. When it comes to Tesla, they don't care. They bid the price up and they keep buying the stock. They believe in it. They don't care about risk. So simply put, to measure the risk premium, it's your risk aversion. How risky you are times the standard deviation of the portfolio. How much the portfolio, the stock is going up and down statistically. We can show this formula as A is the risk aversion. We saw this in another session times the standard deviation of the portfolio. Simply put, the risk premium is the expected return of the minus the risk free rate. This is how we compute the risk premium. So this is an important component of the cap and we're going to be talking about in a moment. So first is the risk premium, expected return minus the risk free rate. Now we need to talk about the beta. What is the beta? Well, we should know about the beta a little bit, but let's review. When you want to measure risk, you compute the standard deviation. The standard deviation of a stock has two components, a systematic risk and an in-systematic firm specific risk. Now beta is the systematic risk. It's the market risk. It's the risk that you cannot diversify. The in-systematic risk, which is the firm specific risk. And if you looked at my previous recording when we talked about diversification, the assumption is we can get rude with enough diversification. We can get rude of this in-systematic risk. Therefore, market does not reward you for this risk, for this in-systematic risk. The market says, look, if you take on in-systematic risk, we will not reward you. Why? Because you should be smart enough to invest in a diversified portfolio where you can get rude of this in-systematic risk. Well, if you can get rude of the in-systematic risk in theory, we're only going to reward you for the systematic risk. So simply put, your reward is based on the beta. Why? Because in-systematic risk, so if you are not smart enough, well, then you're going to bear the in-systematic risk. But what we're saying is if you're not smart, if you are not prudent enough, you will get some in-systematic risk. If you're prudent investor, you should be able to get rude of this and keep only the beta, which is the risk that you cannot diversify. So they will only reward you for the beta. So how do we compute the beta from a beta perspective? Again, if you go to my previous recording, we did this. I'm going to talk about the beta. But basically, it's the standard deviation of the stocks divided by the standard deviation of the market, multiplied by the correlation of the stock and the market together. Well, based on this formula, the greater the standard deviation of the stock, the greater is the beta because the stock volatility is part of the portfolio. So if your stock is volatile, it's going to make the beta higher. Just look at the formula here. If this number is higher, beta will be higher. Same thing. If there's a greater correlation when multiplying by a greater number, you're going to have a greater beta because the stock contribution risk to the portfolio. Because if your stock has a high risk, it's going to contribute to the risk of the portfolio. So simply put, higher beta means a higher risk. If the beta equal to one, it means you have exact, your stock risk is the same as the market. If you have a beta greater than one, your stock has a greater volatility. And I remember when I did this, I showed you Amazon versus Walmart. And if I remember, Amazon stock had a beta of 1.33. And Walmart stock has a beta of 0.32. So Amazon stock will say it's more volatile. It means when the market goes up one point, Amazon goes up 1.33. Same thing. If the market goes down one point, Amazon goes down 1.33. And they measure this by measuring through this formula for a period of time. The same thing for Walmart. Walmart is less volatile. And Walmart, we call it, if it's less than one, it's considered a defensive stock. Now we learn about risk premium. We learn about the beta or basically a review. Let's talk about CAPM. What is CAPM is the expected return of a security giving a certain systematic beta risk because we don't want to talk about the unsystematic risk. So here what we're going to do, we're going to combine beta and risk premium together through this formula. So simply put, here's what we're going to say. We're going to say your expected return is the risk free, which is you're going to earn this plus the risk premium, which we talked about the risk premium, how we compute the risk premium times the beta. So notice what we did. Basically, we took your risk premium. We took your risk premium that you're going to take and we're going to magnify it. We're going to scale it up by the beta. So if you have a high risk premium for your company and you have a high beta, you expect a higher return. Why? Because taking more risk, it's going to reward you. That's basically what it is. If you take more risk and the stock that you're investing in has a high beta, high variation with the market, you'd expect a higher return, more risk, more return. That's basically what we are saying. You are scaling your return based on the beta. So if the beta is one, your return is your risk premium plus the risk free rate. So let's suppose the risk premium of the market portfolio is eight. So this is, we're going to say this is eight percent. The risk premium is eight percent. Sometimes they give you the risk premium. Sometimes they give you the expected return and the risk free and you have to find out the risk premium. Here, they're giving us the risk premium and beta is 1.2, beta 1.2. The risk premium predicted for this stock is eight times 1.2, 9.6. So this, all of this here now is 9.6. So you are taking a risk of eight percent times the beta of the market. And let's assume that the T-bill rate is 3%. Here's what happened. The expected return would be 12.96, which is your market risk premium plus the risk free rate. So it's the 3% plus the 9.6. If your beta was 1.1, what we did is we lowered your beta to 1.1, your risk premium will be 8.8, 1.1 times 8%. And your expected return will be 11.8, which is 8.8 plus 3%. If your beta is 1, well, if your beta is 1, what you're going to do, your risk premium is exactly 8 because the market is not contributing anymore to your return. Your expected return is 8 plus 3 is 11%. If your beta is 1.5, and here we're talking about maybe a tech company where it has a high volatility, it moves more with the market, then it's riskier. Then what's going to happen, your risk premium is 8 times 1.5, which is not 8, 8 times 1.5. It means 8.5. It should be 12. And plus 3, the risk free rate, so your expected return is 15. So notice what we are saying. We are looking at one factor, and that's beta because in this example, all what I did is I changed the beta. And as I change the beta, hopefully you notice, if beta goes up, your return goes up. If beta goes down, your return goes down. And I hope this makes sense because the only thing that's affecting your return, that's what we're assuming. We're dealing with one factor. The only thing that's affecting your return is the market risk, not firm specific risk. Why not? Because we can diversify that firm specific risk. We don't have to worry about it. Now, is this through? Well, we're going to talk about a multi-factor picture. Just going to get a better picture because you could have more factor. But for now, the CAPM tells us when you buy a stock in a portfolio, it's the risk premium times the beta plus the risk free rate is your expected return. And hopefully this make sense. In the next session, I will cover something very related to this session, which is the security market line. The reason I don't want to cover it here because I don't want the recording to be too long. And to explain the security market line, I'm going to have to re-explain a lot of the stuff that I just explained. So you guys will be better off if I cover the security market line, which is very, very much connected to CAPM, basically CAPM and visually in a separate recording. 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