Question

What is Beta? What is the CAPM equation, and what information does the equation provide?

Answer 1

Beta is measure of market risk or systematic risk. Beta represents the proportion of reward to extent of risk taken in form of systematic risk.

Market portfolio is assigned with beta value of 1 as market risk on portfolio will be a benchmark hence value is 1. Risk free security has beta of 0. If a security is less risky than market it will have beta less than 1. If security is highly risky it will have beta more than 1.

How beta is calculated?

Beta = Covariance of (Security, Market)/ Variance of market

Covariance and variance is calculated by using statistical tools or method.

Highly risk security generates more returns hence it has high reward hence beta is way more than market beta.

Beta is used CAPM to calculate the return of securities.

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Capital Asset Pricing Model (CAPM) is very popular model of finance to calculate the return on investment.

CAPM requires below information to calculated the expected return on security:

Ri = Rf + Beta of Ri x (Rm – Rf)

Ri = Expected return on investment, Rf = Risk free rate, Rm = Market Return

CAPM equation represent the return on security given the market return, risk free rate and beta of security.

Higher the beta will throw higher return for security. Risky security generates high return because it has high return and that lures investors. However the objective of CAPM to give us projected return based on inputs of market, beta and risk free rates.