Question

1. Please explain the CAPM that estimate the required rate of return of single asset. Show the formula with the market risk premium. Also explain the beta coefficient.

Answer 1

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital. The formula is given as-

Re = Rf + Beta x (Rm-Rf).

Where Re = required return on asset

Rf = Risk-free return

Rm = Expected Market Return

Rm - Rf = Market Risk Premium.

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.

The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.