Security Market Line And Beta Paper: Beta And The Security Market Line

888 Words4 Pages
Security Market Line and Beta Paper
Risks are everywhere, however that does not mean one has to resort to accepting all levels of risk in the world. Risk is identifiable and as such can be mitigated down to a level where an individual is comfortable with or at the least tolerant of the risk. The stock market requires the use of an individual or business investor’s money and therefore involves considerable amounts of risk. Those who are averse to risk, yet can see the benefits of investing, must due their due diligence prior to investing in a stock that may be considered risky. By using beta and the security market line as tools to identify risk in the market, investors are able to mitigate risky decisions and build a comfortable portfolio that
…show more content…
Beta determines the risk a stock provides to a portfolio. Beta is the measurement of stock risk by using the standard deviation of the stock return, standard deviation of the market return, and the correlation between the stock and market returns (Brigham & Ehrhardt, 2015). Beta uses past data to determine future risk. However, in order for this prediction to be precise, the data behind the calculation must be stable for several years prior to the calculation (Terceño, Barberà-Mariné, Vigier, & Laumann, 2014). A beta higher than one represents higher risk when compared to the market average, and a stock with a beta of less than one represents a lower risk (Brigham & Ehrhardt, 2015). By using this risk calculation, an investor can compare betas of various stocks to determine the amount of risk they are comfortable with in the…show more content…
First of all, the SML equation solves for the required return on stock by using the risk-free rate plus the product of the beta of the stock and the market risk premium (Brigham & Ehrhardt, 2015). For example, an investor is comparing stocks available for purchase from Johnson Manufacturing and Dyer Industries. The betas for the stocks are 1.0 and 1.5 respectively, the risk-free rate is 6%, and the market risk premium is 5%. The required rate of return for Johnson Manufacturing is 11% and the required rate of return for Dyer Industries is 13.5%. Due to the lower risk or beta of the Johnson stock, the investor would expect the rate of return to be at 11%. This example shows that increased risk requires increased

More about Security Market Line And Beta Paper: Beta And The Security Market Line

Open Document