Corporate Finance

Risk and Return 
 73

Company Beta

Bajaj Auto 0.47
BHEL 1.28
Castrol 0.64
Cipla 0.64

Rj= Rf + Risk premium

Rj= Rf + β[E(RM – Rf)]

This relationship between risk and expected return is called the Security Market Line. The risk pre-
mium of a security is a function of the risk premium on the market, RM – Rf, and varies directly with beta.
The higher the beta, the higher the expected return.

Expected return = E(R) = Rf + Amount of risk × Market price of risk

In a financial market described by CAPM no security can sell for long at prices low enough to yield
more than its appropriate return on the SML. The security would then be very attractive compared with
other securities of similar risk and investors would bid its price up until its expected return falls to the appro-
priate position on the SML. Conversely, investors could sell off any stock selling at a price high enough
to put its expected return below its appropriate return.
To reiterate, security return can be divided into components: one dependent, and the other independent of
market return.

Security return = Systematic return + Unsystematic return

Systematic return can be measured by multiplying market return and beta of the stock.

Security Market Line

E(r)
SML

Risk Premium

Rf

1.0 Beta

The CAPM is based on certain assumptions:

• Investors make choices on the basis of risk (i.e., variance) and return.


• Investors have homogeneous expectations of risk and return.


• Investors have identical time horizons.


• Information is freely available to investors.


• There is a risk-free asset and investors can borrow and lend at risk-free rate.


• There are no taxes or transaction costs.

Exhibit 3.14 contd.