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CAPM NOTES There was a lot of material covered in the CAPM lecture, so I want to highlight what you need

to walk away with: The key result of CAPM is that expected returns on securities depend upon how the securities move with the market. This tells us about the volatility, or risk, of a security in relation to the market. The movement of a given security with the market is measured by beta, the covariance of the security to the market over the variance of the market. If a given security moves more than the market (beta >1) , its is more risky than the market and its expected return should be higher than that on the market. If a given security moves less than the market (beta <1), it is less risky that the market and its expected return should be less than that on the market. If a given security moves exactly with the market (beta=1), it is as risky as the market and its expected return should be the same. We also looked at how we can find mispricings in securities based on CAPM. The actual return on a security can be different that that predicted by CAPM, which means that the stock is mispriced. A stock's alpha is the difference between the actual return and the equilibrium return predicted by CAPM. A positive alpha is indicative of an under priced stock (return is higher than it should be). A negative alpha is indicative of an overpriced stock (return is lower than it should be). Why did we bother going through everything prior to these conclusions?? We wanted to derive why it is okay to look at expected returns on individual securities in terms of the market portfolio. The basic conclusion of CAPM is that expected returns fundamentally depend upon how a security moves with the market; that is, if it is more risky, less risky or just as risky as the market.. This only makes sense given the previous conclusions that the market portfolio is the optimal total portfolio for all individual investors. Without conclusions 1-3 we do not have a benchmark optimal portfolio that we can use to compare to individual securities. Conclusions 1-3 allow us to use the market portfolio as our benchmark. How do you calculate beta for a given stock? There are four steps: 1) Calculate the expected return for the market 2) Calculate the variance of the market 3) Calculate the expected return the stock in question 4) Calculate the covariance between the stock and the market Now you have everything you need to find beta. Beta in Real Life

This all might seem dry, tedious and unrelated to the real world. In order to bring a little life to the topic, you can easily look up stock betas. You can find them on Yahoo Finance, under the stock screener section. Go to the following link, http://screen.yahoo.com/stocks.html, and select the sector you want. Make sure to specify the beta fields if you want Yahoo to place the beta next to the company name.

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