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which of the following is NOT a key component of the CAPM? a. beta b. diversifiable...

which of the following is NOT a key component of the CAPM?
a. beta
b. diversifiable risk
c. the risk-free rate
d. the market risk premium

Solutions

Expert Solution

Ans : b. diversifiable risk

Explanation: CAPM model shows the relationship between the return on investment and systematic risk.

  • The risk-free rate accounts for the time value of money.
  • The beta of the investment indicates risk. Beta >1, then stock is a risky stock and vice versa
  • Investment beta is multiplied to the market risk premium, that is, return from market in excess of risk free rate of return. To calculate the return of investment risk-free rate is then added to stock’s beta multiplied by market risk premium.

Formula:

where, ER​ = Expected Return of Investment
Rf​ = risk-free rate
βi ​= beta of the investment
(Rm​−Rf​)=market risk premium​ .

So, by the above formula it is clear that risk-free rate, market risk premium​ &  beta are key components of CAPM model.

Also note that beta is indicative of systematic risk. Systematic risk is the type of risk which cannot be diversified. Hence, we can conclude Diversifiable risk is not a component of CAPM model.

jeff jeffy answered 1 year ago
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