# INTEREST RATES AND RISK PREMIUMS by mustarhymes

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```									                                CAPITAL ASSET PRICING MODEL (CAPM)

   Systematic versus unsystematic risk:
    Systematic risk—market (economic) risk that cannot be reduced through diversification.
    Unsystematic risk—risk unique to the firm/industry that can be reduced (theoretically to
zero) through diversification
   Equilibrium model:
E (ri )  rf  RPi
 rf  RPM β i
 rf  [E(rM )  rf ]β i
 Cov(ri , rM ) 
 rf  [E(rM )  rf ]               
    σ2
M         
   Security Market Line (SML)—a graphical depiction of the CAPM

E(r)

Security Market Line (SML)

E(rM )  rf
E(rM)                                           Slope                 E(rM )  rf
1.0  0

rf

                                       

   Computing —beta is computed using the market model, which when graphed is termed the
characteristic line:

ri,t = i + irM,t + i,t

i represents the beta for a stock, i; it is a measure of the volatility of the stock's returns relative
to the volatility of the market's return.
   CAPM shortcomings:
     assumptions
     testing the CAPM
   Practicality of the CAPM
   Portfolio beta:      P = w11 + w22 + … + wNN
Stock Return
(GM)
30%

20%

10%

0%
Market Return
-20%           -15%         -10%        -5%            0%         5%         10%           15%    (S&P 500)

-10%
 = intercept = 0,2%

-20%
 = slope = 1.20
-30%

SUMMARY OUTPUT

Regression Statistics
Multiple R              0.561453366
R Square                0.315229882
Adjusted R Square       0.303423501
Standard Error          0.097661962
Observations                       60

ANOVA
df                  SS                 MS            F          Significance F
Regression                             1      0.254660427     0.254660427     26.69995769      3.05702E-06
Residual                           58         0.553195811     0.009537859
Total                              59         0.807856238

Coefficients        Standard Error      t Stat          P-value       Lower 95%       Upper 95%      Lower 95.0%       Upper 95.0%
Intercept              -0.002148682           0.012610387    -0.170389864     0.865296529     -0.027391095    0.02309373    -0.027391095        0.02309373
X Variable 1             1.20181219           0.232584794     5.167200179     3.05702E-06       0.73624349   1.667380891         0.73624349    1.667380891

```
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