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Finally, if the numerator in the beta calculation is less than the denominator, the covariance between
the stock and the overall market is low—possibly because the returns of the stock and the returns of
the market are not highly correlated, and possibly because the standard deviation of returns for the
stock is low. In this case, the stock may or may not move in the same direction as the overall market,
and if it does move in the same direction, these movements are of small magnitude. A stock with these
characteristics has lower than average risk when held in a portfolio, as reflected in its beta coefficient
of less than 1.0.
The beta coefficients published by a well-known source, Value Line, Inc., for several well-known
firms, are listed in Exhibit 5.5.
These companies were chosen to show a wide range of beta coefficients. One company, Boeing, has
a beta coefficient of 1.0, so it has the same amount of systematic risk as the stock market overall,
making it an average risk stock when included in a portfolio. Four companies have beta coefficients
less than 1.0, so these firms are all of lower than average risk when held in a portfolio. Five of the
companies in the table, in contrast, have beta coefficients greater than 1.0, so these firms are all of
higher than average risk when held in a portfolio. Again, market or systematic risk cannot be
eliminated by diversification, so knowing a stock‟s beta coefficient tells you the amount of risk the
stock contributes to a portfolio, which allows you to calculate the expected return on the stock, given
its level of risk.
To summarize, the capital asset pricing model is based on the following logic:
• Unique or nonsystematic risk can be eliminated by diversification, so it is not relevant and
not rewarded.
• Market or systematic risk cannot be eliminated and is therefore relevant and rewarded.
• The correct measure of market or systematic risk is beta, the covariance of the returns of
the stock with the returns of the market, divided by the variance of the returns of the market,
which indicates how exposed a stock is to market or systematic risk.
The CAPM Equation
The expected return of any stock is calculated as the expected risk-free return, plus an additional
return based on the expected risk premium for investing in the market, times the beta coefficient of the
stock. The CAPM equation for the expected return of any stock looks like this: