Question

Based on the theory presented by the Capital Asset Pricing Model, there are three components that comprise the expected return on a risky asset. Define each component and explain what role that particular component plays in determining expected return

Answer 1

The three components work in conjunction with each other to measure the risk and return of the asset to give the CAPM formula of CAPM = Rf + B * MRP

The three components are:

1. Risk Free return - usually the current yield on treasury bonds. It's a measure of return of an asset with no risk whatsoever. Investors will obviously demand a higher return for a risky asset than the riskless rate.


2. Market Risk Premium - The expected return of the overall market minus the return of the risk free asset. For example, if the risk free return is 7% and market return is 12%, the MRP is 5%. This measures the excess return investors demand for bearing the greater risk of the overall market compared to the risk free rate.

3. Beta - A measure of relative volatility (risk) of the asset compared to the overall market. A Beta of 1 implies the asset is as volatile as the market, a Beta greater than 1 is more volatile, and less than 1 is less volatile. If your Beta is greater than one, you are basically bearing more risk than the overall market, fo the risk premium associate with the asset will be greater than the overall MRP (think of the last part of the formula, which is Beta * MRP)