Corporate Finance

Term 1 - Fall 2014

Professor Abe
October 29, 2014

Thoughts on CAPM, Standard Deviation, Beta, and the SML

1. The Capital Asset Pricing Model (CAPM) is an explanatory economic model. CAPM is
not a precisely predictive model. However, by using CAPM, one can determine a
precise measurement of a companys cost of capital.
But, remember that the component values of CAPM are based on past data. You
cannot assume that the past will predict the future with precision.
Also, the components of the CAPM can be defined differently. For instance, what
percentage expected return should be used for the market risk premium, how to
calculate beta, and is the risk free rate a three month or 10 year government security?
So, with all these factors subject to so much interpretation, is CAPM useless?
Not at all, since CAPM does provide a framework for understanding how risk can be
measured in the capital market context. In practice, in fact, CAPM is a commonly used
tool for determining a companys cost of capital.
2. A stocks standard deviation and its beta are NOT the same. Standard deviation is a
measurement of a stocks price variability from investors mean expected return (stock
compared to itself), while beta measures a stocks price sensitivity to overall market
movements (stock compared to the market). Both are measurements of risk.
Intuitively, higher beta = higher risk = higher expected return demanded by investors.
A beta >1 will amplify the market risk premium in the CAPM formula leading to a higher
cost of capital for a company. And, conversely, a beta <1 will lower the cost of capital
for a company.
3. In a portfolio context, the standard deviation of a particular stock can be separated into
two risk factors: unique risk and market risk. Beta measures only the market risk
component and not the unique risk component of a stocks standard deviation.
4. Beta is a measurement that is calculated using regression analysis. As a result, betas
accuracy is a function of the degree of spread of the data points used. If R-squared is
under .5, the beta is not very reliable. In such cases, practitioners will revert to an
industry beta (the betas of several companies within the same industry) rather than
using the companys individual stock beta
5. Security Market Line (SML): I personally like the SML as a concept because it is logical.
In theoretical equilibrium, all stocks should lie on the SML since their expected returns
should equate to their risks. Thats the theory. In practice, investors search for
mispriced securities that are off the SML in order to earn abnormal returns. This is a
market efficiency question.

END