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Briefly describe the CAPM model. Why stock/portfolio's expected returns are associated with market risk premium

Briefly describe the CAPM model. Why stock/portfolio's expected returns are associated with market risk premium

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Expert Solution

Capital Asset Pricing Model (CAPM)

CAPM shows risk return trade off of securities . It shows linear relation between risk and return.

As per CAPM there are 2 types of risk.

· Unsystematic/Company Specific/Diversifable Risk : This risk can be eliminated by diversification.

· Systematic / Market Specific risk : This risk cannot be eliminated by diversification.

As per CAPM business should be concerned with Systematic Risk which is not diversifiable , which is assessed in terms of beta coefficient (b).

As per CAPM

Cost of equity (ke) = Rf + B (Rm – Rf)

where

Ke = cost of equity capital

Rf = Risk free rate of return.

B = Beta coefficient

Rm = Rate of return of market portfolio.

Rm-Rf = Market risk premium.

Rate of Return = Risk Free Rate + Risk Premium.

Answer to “ Why rate of return are associated with market risk premium”

· As per CAPM model , investor should be compensated for time value of money & risk.

· Time Value of money is compensated by risk free retuen.

· Second part of formula represent risk which shows the amount of compensation paid to investor for taking additional risk.

· Risk Premium is calculated by taking a risk premium known as beta which compares the return of asset to the market over a period of time and compares it to market premum.

CAPM says expected return of security should be more than risk free return plus risk premium , if it is not so investment should not be accepted

jeff jeffy answered 1 year ago
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