Question

Ri = [Rf + ((Rm – Rf) x Bi)]

Please define and explain the following components:

• Ri
• Rf
• (Rm – Rf)
• Bi

What does the CAPM tell us about the required return on a risky investment?

Answer 1

Ri is the required return on the stock .If stock is in equilibrium then this required return is equal to expected return on stock .When we calculate required return as per the given formula then it is considered that only systematic risk is relevant and therefore compensation for that risk is considered ,it is considered that there is no firm specific risk

Rf is equal to risk free return that means how much return we can earn without taking any risk .This return is sometimes takes as the return on treasury bill

(Rm-Rf) is called market risk premium that means market return less risk free return .It tells us the excess return on market Portfolio.It is the slope of security market line

Bi is the beta of stock. It represents sensitivity of stock with respect to market that means how much stock will change if there is 1 percent change in market return.We can also say, it represents market risk.

CAPM i.e Capital asset pricing model is the relationship between required return and systematic risk represented by beta.This model believes that there is no firm specific risk when we invest in market portfolio ,the only risk which is relevant is market or systematic risk and therefore this model considers compensation only for market risk while calculating required return .The equation given in the question is CAPM equation .