Fundamentals of Financial Management (Concise 6th Edition)

248 Part 3 Financial Assets

We can summarize our discussion up to this point as follows:

1. A stock’s risk has two components, diversi" able risk and market risk.


2. Diversi" able risk can be eliminated; and most investors do eliminate it, either
   by holding very large portfolios or by buying shares in a mutual fund. We are
   left, then, with market risk, which is caused by general movements in the stock
   market and re! ects the fact that most stocks are systematically affected by
   events such as wars, recessions, and in! ation. Market risk is the only risk that
   should matter to a rational, diversi" ed investor.


3. Investors must be compensated for bearing risk—the greater the risk of a
   stock, the higher its required return. However, compensation is required only
   for risk that cannot be eliminated by diversi" cation. If risk premiums existed
   on a stock due to its diversi" able risk, that stock would be a bargain to well-
   diversi" ed investors. They would start buying it and bid up its price, and the
   stock’s " nal (equilibrium) price would be consistent with an expected return
   that re! ected only its market risk.
   To illustrate this point, suppose half of Stock B’s risk is market risk (it
   occurs because the stock moves up and down with the market), while the
   other half is diversi" able. You are thinking of buying Stock B and holding it in
   a one-stock portfolio, so you would be exposed to all of its risk. As compensation
   for bearing so much risk, you want a risk premium of 8% over the 6% T-bond
   rate; so your required return is rA $ 6% " 8% $ 14%. But other investors,
   including your professor, are well diversi" ed. They are also looking at Stock B;
   but they would hold it in diversi" ed portfolios, eliminate its diversi" able risk,
   and thus be exposed to only half as much risk as you. Therefore, their required
   risk premium would be half as large as yours, and their required rate of return
   would be rB $ 6% " 4% $ 10%.
   If the stock was priced to yield the 14% you require, those diversi" ed
   investors, including your professor, would buy it, push its price up and its
   yield down, and prevent you from getting the stock at a price low enough to
   provide the 14% return. In the end, you would have to accept a 10% return or
   keep your money in the bank.


4. The market risk of a stock is measured by its beta coef" cient, which is an index
   of the stock’s relative volatility. Here are some benchmark betas:
   b $ 0.5: Stock is only half as volatile, or risky, as an average stock.
   b $ 1.0: Stock is of average risk.
   b $ 2.0: Stock is twice as risky as an average stock.

Tabl e 8 - 5 Illustrative List of Beta Coefficients

Stock Beta

Merrill Lynch 1.35

Best Buy 1.25

eBay 1.20

General Electric 0.95

Microsoft 0.95

ExxonMobil 0.90

Heinz 0.80

Coca-Cola 0.75

FPL Group 0.75

Procter & Gamble 0.65

Source: Adapted from Value Line, February 2008.