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Does a risk free asset have a beta of one?

Updated: 9/18/2023
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Dhedden

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Q: Does a risk free asset have a beta of one?
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Is it possible that a risky asset have negative beta?

Yes, it is possible that a risky asset may have a negative beta. Given that beta measures "relative risk" to a particular market, index, etc., a negative beta suggests that the the particular asset class performs well when the given market (the market/index to which the beta was computed) performs poorly (negative coorelation). Using the phrase "risky asset" only suggests that the asset's ability to return value to the investor is volatile. For example, a new set of ETFs released in November 2008 track the Case-Shiller housing index. The first, UMM (NYSE), goes up when home prices go up. The second, DMM (NYSE), goes down when home prices go down. If we assume that the Case-Shiller index is the basis for beta computations, one would expect UMM's beta to be positive (2.0 since the securities have leverage of 200%) and DMM's beta to be negative (-2.0). At the end of the day, negative beta opportunities are good in that they provide a way to diversify out different types of risk in a portfolio holding multiple asset classes.


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1 What is the relationship between risk and return as per CAPM?

Capital Asset Pricing Model (CAPM), is a theory that explains how asset prices are formed in the market place. The CAPM is an extension of portfolio theory(Markowitz) which was developed by William Sharpe, John Lintner and Jan Mossin to examine what would be the relationship between risk and return in the capital market if investors behaved in conformity with the prescription of portfolio theory. The CAPM has implications for:Risk-return relationship for an efficient portfolioRisk-return relationship for an individual asset or securityIdentification of under and over-valued assets traded in the marketPricing of assets not yet traded in the marketEffect of leverage on cost of equityCapital budgeting decisions and cost of capital andRisk of the firm through diversification of project portfolio.Assumptions of CAPM:Individuals are risk-averse.Individuals seek to maximize the expected utility of their portfolios over a single period planning horizon.Individuals have expectations that are homogeneous. This essentially means that they have similar subjective estimates of the means, variances and covariances among returns.Investors can borrow and lend freely at the riskless rate of interest.The market is perfect. The assumption is that there are no taxes, no transaction costs, securities are completely divisible and the market is also competitive.The quantity of risky securities in the market is given.Elements of the CAPM:There are 2 elements of the CAPM. They are:Capital Market Line andSecurity Market Line.Capital Market Line:It depicts the risk-return relationship for efficient portfolios. It serves two functions. Firstly, it depicts the risk-return relationship for efficient portfolios available to investors. Secondly, it shows that the appropriate measure of risk for an efficient portfolio is the standard deviation of return on the portfolio.Security Market Line:It is a graphic representation of CAPM and describes the market price of risk in capital market. Risk averse investors seek risk premium to invest in risky assets. The risk is variability in return and the total risk consists of both systematic risk and unsystematic risk. Generally, the investor can avoid unsystematic risk by diversifying his investment in portfolio. But systematic risk is unavoidable. The market compensates for systematic risk only, according to the capital market theory. The level of systematic risk in an asset is measured by the beta coefficient, represented by the symbol β. The CAPM links beta to the level of required return.CAPM model: Ke= Rf+ β (Km- Rf)Where:Ke=Expected return or cost of equityRf=Risk-free rateβ=Beta or Beta coefficientKm=Expected return on market portfolio (or) equity market required returnSecurity Market Line (SML)Example 1:Given: Required rate of return on a portfolio = 17%; Beta = 1.1; Risk-free rate = 5%. What is the expected rate of return on the market portfolio?Ke= Rf+ β (Km- Rf)17% = 5% + 1.1 (Km– 5%)Km= 0.159 or 15.9% or 16%.Example 2:Given, the risk-free rate is 8%; Expected return on market portfolio = 14%; Beta = 1.25. Investors believe that stock will provide an expected return of 17%. What is the expected return as per CAPM and the "alpha" of the stock?Expected return as per CAPM=0.08 + 1.25 (0.14 - 0.08)=>0.155 or 15.5%.Alpha of the stock = 17.00% -15.55%=>1.5%(The excess return over the expected return according to the CAPM is termed as "alpha").Online Live Tutor Finance Capital Asset Pricing Model (CAPM):We have the best tutors in finance in the industry. Our tutors can break down a complex Capital Asset Pricing Model (CAPM) problem into its sub parts and explain to you in detail how each step is performed. This approach of breaking down a problem has been appreciated by majority of our students for learning Capital Asset Pricing Model (CAPM) concepts. You will get one-to-one personalized attention through our online tutoring which will make learning fun and easy. Our tutors are highly qualified and hold advanced degrees. Please do send us a request for Capital Asset Pricing Model (CAPM) tutoring and experience the quality yourself.Online Capital Asset Pricing Model (CAPM) Help - Finance:If you are stuck with a Capital Asset Pricing Model (CAPM) Homework problem and need help, we have excellent tutors who can provide you with Homework Help. Our tutors who provide Capital Asset Pricing Model (CAPM) help are highly qualified. Our tutors have many years of industry experience and have had years of experience providing Capital Asset Pricing Model (CAPM) Homework Help. Please do send us the Capital Asset Pricing Model (CAPM) problems on which you need Help and we will forward then to our tutors for review.


How is the Treynor ratio Annualized?

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