Analysis Intermediate: Evaluating Risk

Introduction to Evaluating Risk Risks and Returns Standard Deviation Reflects Investment Volatility Beta Compares Investment Risk to the Market Coefficient of Variation Indicates Proportionate Risk Choose Investments Based on Risk Tolerance Summary of Evaluating Risk
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Risks and Returns

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Risks and Returns

Generally, the higher the volatility of your investment, the greater the expected return. Investors who take risks expect to be rewarded for taking those risks.

Things To Know

  • The higher the volatility, the greater the expected return.
  • The CAPM examines the relationship between risk and return.

How the capital asset pricing model fits in

The capital asset pricing model (CAPM) examines the relationship between risk and return for a given asset. CAPM is often used as a model for pricing risky securities. CAPM uses a formula to determine a security’s maximum expected return for a given level of risk. It assumes that most investors prefer less risk and will demand compensation for the amount of risk they take.

The CAPM formula

The capital asset pricing model

In this equation, "r" stands for return, Rm stands for market rate of return, Rf stands for risk-free return (the return of a "risk free" investment such as a Treasury bill), and β represents beta.

An example

Although the formula looks complicated, it’s not. For example, let’s say you want to know the expected return of a stock with a risk-free rate of return of 5 percent and a market rate of return of 6 percent. The stock’s beta is 2. So:

The capital asset pricing model

You could expect a return of 7 percent on this investment!