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Capital Asset Pricing Model, Part Two – Systematic Risk

Capital Asset Pricing Model, Part Two – Systematic Risk

We are reviewing the underlying assumptions made by the Capital Asset Pricing Model (CAPM). Recall from last time the assumption that returns are distributed normally (i.e. a bell-shaped curve) and how this fails to account for skew and fat tails. Today we’ll look at CAPM’s assumption that there is but a single source of priced systematic risk: market beta.

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Copyright 2011 Eric Bank, Freelance Writer
Beta

Beta

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Hedge funds use an array of strategies to guide trading.  Most of these strategies seek to decouple returns from those of the overall market, as measured by a statistic called “beta” (β). Beta is calculated by dividing the covariance of an investment’s return by the variance of a portfolio or market return:

βi = Cov (ri, rm) / Var(rm) where i = an investment, m = market portfolio, and r = return

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Copyright 2010 Eric Bank, Freelance Writer