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. Your response should be in the form of a Word or PDF document consisting of 100-300 words. Cite any sources you consult to inform your response.

Answer 1

Capital Asset Pricing model has three components:

Retrun on risk free asset

Beta

Equity risk premium

Rate of return = risk free return + beta(equity risk premium)

Risk Free asset:

A risk free asset is defined as an asset that has no default risk. A common proxy for risk-free rate is the yield on a default-free government debt instrument. In general, the selection of appropriate risk-free rate should be guided by the duration of projected cash flows. If we are evaluating a project with an estimated useful life of 10 years, we may want to use the rate of a 10-year treasury bond.

Beta:

Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility. It measures a stock's relative volatility – that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.

Equity risk premium:

The expected market premium is the premium that investors demand for investing in a market protfolio relative to risk free rate. It shows the amount of compensation equity investors need for taking on additional risk.