firm-specificrisk.Statistically,wecanmeasuretheriskadded
byanassettothemarketportfoliobyitscovariancewiththat
portfolio. The covariance is a percentage value and it is
difficulttopassjudgmentontherelativeriskofaninvestment
bylooking atthisvalue. Inotherwords, knowingthat the
covarianceofGooglewiththemarketportfoliois 55 percent
doesnotprovideusaclueastowhetherGoogleisriskieror
saferthantheaverageasset.Wethereforestandardizetherisk
measureby dividing thecovarianceof eachasset with the
marketportfoliobythevarianceofthemarketportfolio.This
yields thebetaof the asset:
Sincethecovarianceofthemarketportfoliowithitselfisits
variance,thebetaofthemarketportfolio,andbyextension
the average asset in it, is 1. Assets that are riskier than
averagewillhavebetasthataregreaterthan 1 andassetsthat
aresaferthanaveragewillhavebetasthatarelessthan1.The
risklessassetwillhaveabetaof0.Theexpectedreturnofany
assetcanbewrittenasafunctionoftherisk-freerate,thebeta
of that asset, and the risk premium for investing in the
average-risk asset:
Insummary,intheCAPM,allthemarketriskiscapturedin
thebeta, measuredrelativeto a market portfolio,which at
least in theory should include all traded assets in the
marketplace held in proportion to their market value.