Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

© The McGraw−Hill^459

Companies, 2002

Measuring Systematic Risk

Because systematic risk is the crucial determinant of an asset’s expected return, we need
some way of measuring the level of systematic risk for different investments. The spe-
cific measure we will use is called the beta coefficient, for which we will use the Greek
symbol. A beta coefficient, or beta for short, tells us how much systematic risk a par-
ticular asset has relative to an average asset. By definition, an average asset has a beta
of 1.0 relative to itself. An asset with a beta of .50, therefore, has half as much system-
atic risk as an average asset; an asset with a beta of 2.0 has twice as much.
Table 13.8 contains the estimated beta coefficients for the stocks of some well-known
companies. (This particular source rounds numbers to the nearest .05.) The range of be-
tas in Table 13.8 is typical for stocks of large U.S. corporations. Betas outside this range
occur, but they are less common.
The important thing to remember is that the expected return, and thus the risk pre-
mium, on an asset depends only on its systematic risk. Because assets with larger betas
have greater systematic risks, they will have greater expected returns. Thus, from Table
13.8, an investor who buys stock in Exxon, with a beta of .75, should expect to earn less,
on average, than an investor who buys stock in General Motors, with a beta of about 1.05.
One cautionary note is in order: not all betas are created equal. Different providers
use somewhat different methods for estimating betas, and significant differences some-
times occur. As a result, it is a good idea to look at several sources. See our nearby Work
the Webbox for more on beta.

CHAPTER 13 Return, Risk, and the Security Market Line 431

Total Risk versus Beta

Consider the following information on two securities. Which has greater total risk? Which has

greater systematic risk? Greater unsystematic risk? Which asset will have a higher risk

premium?

From our discussion in this section, Security A has greater total risk, but it has substan-

tially less systematic risk. Because total risk is the sum of systematic and unsystematic risk,

Security A must have greater unsystematic risk. Finally, from the systematic risk principle, Se-

curity B will have a higher risk premium and a greater expected return, despite the fact that it

has less total risk.

Standard Deviation Beta

Security A 40% 0.50

Security B 20 1.50

EXAMPLE 13.5

TABLE 13.8

Beta Coefficients for

Selected Companies

Slide13.29

Beta Coefficient (i)

American Electric Power .55

Exxon .75

IBM .95

General Motors 1.05

Harley-Davidson 1.20

Abercrombie & Fitch 1.30

AOL-Time Warner 1.75

Source: Value Line Investment Survey,2001.

beta coefficient

The amount of

systematic risk present

in a particular risky asset

relative to that in an

average risky asset.