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How Safe is Your Sector? Discover potential returns for taking sector risk in stocks and bonds.
BY Jodie Gunzberg

In this paper, the required returns of stock and bond sectors will be analyzed to understand weighting opportunities within each asset class and to find the relative value between asset classes within each sector. Also, a duration factor will be introduced to adjust for required returns in the corporate bond sectors. Finally, a measure of market sentiment will be explored by studying the history of sector risk premiums, which shows optimism when market participants hope to benefit from the upside of stocks and pessimism when they prefer the potential protection offered by bonds.

The Capital Asset Pricing Model (CAPM)1 is a well-known economic theory that describes the return one may expect from investing in a single asset like a stock. The logic behind the idea is that one expects a higher return for holding an asset riskier than the market portfolio, where the market portfolio is a well-diversified basket that only contains systematic risk, or undiversifiable market risk. Typically in CAPM, the risk measure that helps value a single stock is called beta.3 Beta is the sensitivity of a single stock to the market portfolio as measured by the ratio of the covariance of the single stock and the market portfolio to the variance of the market portfolio. The S&P 500® is commonly used as the benchmark for the market portfolio to represent large-cap U.S. stocks and the associated market risk.

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