Question

The Capital Asset Pricing Model, says that returns are predictable if you know the risk free rate, the market risk premium, and beta. True or False?

Answer 1

True

Explanation:

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.

Corporate Finance Institute

Capital Asset Pricing Model (CAPM)

A method for calculating the required rate of return, discount rate or cost of capital

Resources > Knowledge > Finance > Capital Asset Pricing Model (CAPM)

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.

[CAPM illustration]

CAPM formula and calculation

CAPM is calculated according to the following formula:

Ra = Rrf + [Ba × (Rm-Rrf)]

Where:

Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used to calculate the expected return on investable asset. It is based on the premise that investors have assumptions of systematic risk (also known as market risk or non-diversifiable risk) and need to be compensated for it in the form of a risk premium – an amount of market return greater than the risk-free rate. By investing in a security, investors want a higher return for taking on additional risk.

Thus we can predict the return if we know Rrf, Rm and beta by using CAPM