o

Cost of equity
Ke (or any other risky asset) is given by the Capital Asset Pricing
Model

(CAPM)
Where
Rf = Risk-free rate
= Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market
Risk-free Rate
The theoretical rate of return of an investment with zero
risk, including default risk.
o Default risk
The risk that an individual or company would
be unable to pay its debt obligations.
Represents the interest an investor would expect from an
absolutely risk-free investment over a given period of
time.
Equity Risk Premium
The equity risk premium reflects fundamental judgments
we make about how much risk we see in an
economy/market and what price we attach to that risk. In
effect, the equity risk premium is the premium that
investors demand for the average risk investment and by
extension, the discount that they apply to expected cash
flows with average risk.
A central component of every risk and return model in
finance and is a key input into estimating costs of equity
and capital in both corporate finance and valuation.
Beta
Measure of the systematic risk of a security that cannot
be avoided through diversification. Therefore, Beta
measures non-diversifiable risk.
It is a relative measure of risk: the risk of an individual
stock relative to the market portfolio of all stocks.
A statistical measurement indicating the volatility of a
stocks price relative to the price movement of the overall
market.
Higher-beta stocks mean greater volatility and are
therefore considered to be riskier but are in turn supposed

to provide a potential for higher returns; low-beta stocks

pose less risk but also lower returns.
The market itself has a beta value of 1; in other words, its
movement is exactly equal to itself (a 1:1 ratio). Stocks
may have a beta value of less than, equal to, or greater
than one.
An asset with a beta of 0 means that its price is not at all
correlated with the market; that asset is independent.
A positive beta means that the asset generally tracks the
market. A negative beta shows that the asset inversely
follows the market; the asset generally decreases in value
if the market goes up.

Higher-beta stocks tend to be more volatile and therefore

riskier, but provide the potential for higher returns. Lowerbeta stocks pose less risk but generally offer lower
returns.
Problems with Beta
While it may seem to be a good measure of risk, there are
some problems with relying on beta scores alone for
determining the risk of an investment.
o Beta is not a sure thing.
o Beta scores merely suggest how a stock, based on
its historical price movements will behave relative
to the market. Beta looks backward and history is
not always an accurate predictor of the future.
o A stocks beta may change over time though
usually this happens gradually.
Risk Adjusted Return (Sharpe Ratio)

Sharpe index / Sharpe measure / reward-to-variability

ratio
A measure of the excess return (or risk premium) per unit
of risk in an investment asset or a trading strategy.

The Sharpe ratio is a risk-adjusted measure of return that

is often used to evaluate the performance of an asset or a
portfolio.

The ratio helps to make the performance of one portfolio

comparable to that of another portfolio by making an
adjustment for risk. It is excess return generated for an
asset or a portfolio for every one unit of risk.