Wednesday, December 9, 2009


Beta Estimation

Net present value of an investment is the discounted value of its future cash flows. The capital asset pricing model risk return framework provides us with a method of determining the discount rate of an investment.

The risk of a portfolio of securities is measured by its variance or standard deviation. The variance of a portfolio is the sum of;
  • The variances of individual securities times the square of their respective weight and,
  • The covariance that is the correlation coefficient between securities times their standard deviations of securities times twice the product of their respective weights.

In a well diversified portfolio the weights of individual securities will be very small and therefore, the variance of individual securities will be quite insignificant. But the covariance between the securities will be significant, and its magnitude will depend on the correlation coefficients between securities.

The covariance will be negative if all securities in the portfolio are negatively correlated. In practice, securities may have some correlation because they all have a tendency to more with the market.

This logic introduces the concepts of diversifiable risk and non diversifiable risk. The unique or the unsystematic risk of a security can be diversified when it is combined with other securities to form a well diversified portfolio.

On the other hand, the market or the systematic risk of the security cannot be diversified because like other securities, it also moves with the market.

There are two methods to calculate systematic risk of a security,

  1. Direct method.
  2. The market model.

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