FINANCE Corporate financial policy and R and D Management

Prize in Economic Sciences for their work. An investor is not compensated
for bearing risk that may be diversified away from the portfolio. The beta
is the slope of the market model, in which the stock return is regressed as a
function of the market return. The difficulty of measuring beta and its cor-
responding Security Market Line (SML) gave rise to extramarket measures
of risk, found in the work of King (1966), Farrell (1974), Rosenberg
(1974, 1976), Rosenberg and Marathe (1979), Stone (1974), and Stone,
Guerard, Gultekin, and Adams (2002), Ross (1976), and Ross and Roll
(1980). The BARRA risk model, developed in the series of studies by
Rosenberg and completely discussed in Grinhold and Kahn (1999), is dis-
cussed later in this chapter.
The CAPM holds that the return to a security is a function of the secu-
rity beta.

Rjt= RF+ βj[E(RMt) – RF] + ej (8.7)

where Rjt= expected security return at time t
E(RMt) = expected return on the market at time t
RF= risk-free rate
βj= security beta
ej= randomly distributed error term

Let us examine the capital asset pricing model beta, its measure of sys-
tematic risk, from the Capital Market Line equilibrium condition.

(8.8)

E(Rj) = RF+ [E(RM) – RF]βj (8.9)

The Security Market Line (SML), shown in equation (8.9), is the linear re-
lationship between return and systematic risk, as measured by beta.
Let us estimate beta coefficients to be used in the capital asset pricing
model (CAPM), to determine the rate of return on equity. One can regress

ER R

ER R

RR

RER R

RR

R

jF

MF

M

jM

FMF

jM

M

()

()

(, )

[( ) ]

(, )

()

=+

 −















=+−

σ^2

Cov

Cov

Var

βj

jM

M

RR

R

=

Cov

Var

(, )

()

210 THE USE OF FINANCIAL INFORMATION IN THE RISK AND RETURN OF EQUITY