CAPM describes the relationship between the expected rates of return on risky assets in terms of...

CAPM describes the relationship between the expected rates of return on risky assets in terms of their systematic risk. Its value depends on what things? And why are these things so important?

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Expert Solution

CAPM ( Capital Asset Pricing Model) uses the following formula to determine the required rate of return on a stock.

CAPM depends upon the following things:

Risk Free Rate on Risk Free Assets
Expected Market return on stock
Beta which is the correlation of stock return with market returns.

Importance of the components of CAPM:

Risk Free Rate : This rate compensates the investors for placing money in any investment over a period of time. These rates are generally of T-bills issued by government, which is assumed to be the risk-free and is not affected by market fluctuations.
Expected market return on stock : The rate is the return of stock in market over a period. This is imortant as it tells how much return is expected when investment is done in stocks.
Beta: Beta is the risk- measure the volatlity of the stock and the market as well as the correlation between the stock and the market. It is important as investors will be interested in knowing how much risky is the stock to the market, so as they do not experience huge losses, and if they are ready to take the risk of an risky stock, they must be compensated with higher returns.

jeff jeffy answered 1 year ago

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