Business Finance

The Capital-Asset Pricing Model (CAPM):

A model that describes the relationship between risk and expected (requried)
return; in this model, a securities expected (required) return is the risk-free
rate plus a premium based on the systematic risk of the security.

Standard and poors 500 stock index (S&P 500 index):

A market value weighted index of 500 large captalization common stocks
selected from a broad cross section of industry groups. It is used as a
measure of overall market performance.

Characteristic Line:
A line that describes the relationship between an individual securitys returns
and returns on the market portfolio. The slope of this line is beta.

Formula:

where:
i is called the asset's alpha (abnormal return)
i(RM,t Rf) is a nondiversifiable or systematic risk
i,t is the non-systematic or diversifiable, non-market or idiosyncratic risk
RM,t is a market risk
Rf is a risk-free rate
The monthly returns are calculated as:

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( Dividend paid)+(ending pricebeginning price)

Beginning price

Beta:
An index of systematic risk.It measures the sensitivity of a stocks returns to
changes in returns on the market portfolio.The beta for a portfolio is simply a
weighted average of the individual stock betas in the portfolio.

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Security Market Line (SML):

A line that describes the linear relationship between expected rates of return
for individual securities (and portfolios) and systematic risk, as measured by
beta.

Security Market Line:

R
j= Rt + ( R m Rt)j
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk of stock j),
RM is the expected return for the market portfolio.
For exaple:
Rj= 0.08 + (0.13- 0.08)(1.3) = 14.5%

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Ticker symbol:
A unique, letter caharacter code name assigned to securities and mutual
funds. It is often used in newspapers and price quotation services. This
shorthand

method

of

identification

was

originally

developed

in

the

nineteenth century by telegraph operators.

Adjusted beta:
An estimate of a securitys future beta that involves modifying the security
historical (measured) beta owing to the assumption that the securitys beta
has a tendency to move over time toward the everage beta for the market or
the company industory.
Returns and stock prices:
The capital asset pricing model provides us a means by which to estimate
the required rate of return on a security. This return can then be used as the
discount rate in a dividend valuation model. You will recall that the intrinsic
value of a share of stock can be expressed as the present value of the
stream of expected future dividends. That is

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t=1

Dt
( 1+ ke ) t

Where Dt is the expected dividend in period t,

Ke is the required rate of return for the stock,
and is the sum of the present value
suppose that we wish to determine the value of the stock of Savance
corporation and that the perpetual dividend growth model is appropriate.
This model is

V=

Dt
keg

Where g is the expected annual future growth rate in dividends per share.
Furthermore, assume that Savance Corporation expected dividend in period
1 is $2 per share and that expected annual growth rate in dividends per
share is 10 percent. We determined that the required rate of return for
Savance was 14.5 percent. On the basis of these expectations, the value of
stock is:

V=

$ 2.00
(0.1450.10)

= $44.44

Morever, the growth rate of the companys dividends also declines

somewhat. The variables, both before and after these changes, are listed
below.
Before
Risk free rate, Rt

After
0.08

0.07

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Expected market return,

R
m

Savance beta, j

0.13
1.30

Savance dividend growth rate, g

0.10

0.11
1.20
0.09

The required rate of return for Savance stock, based on systematic risk,
becomes

R
j= Rt + ( R m Rt)j

R
j= 0.07 + (0.11 0.07)(1.20) = 11.8%
Using this rate as ke, the value of stock is

V=

$ 2.00
0.1180.09

= $71.43

Thus the combination of these events causes the value of the stock to
increase from $44.44 to $71.43 per share. If the expectation of these events
represented the market consensus, $71.43 would also be the equilibrium
price. Thus the equilibrium price of a stock can change very quickly as
expectations in the marketplace change.