In: Finance
What is the importance of the capital asset pricing model in finance? In your answer, identify what might be the best proxy for (1) the risk-free rate and (2) the market rate of return.
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Capital asset pricing model or CAPM is used to calculate the
cost of equity.
The CAPM formula is given as:
Cost of equity = Risk free rate + Beta*Risk premium
Where, risk premium=Expected market return-Risk free rate
Weighted average cost of capital is used in discounting the future cash flows of a company. Cost of equity is a component in the weighted average cost of capital. So, we can say that, cost of equity is used to determine the price an investor is willing to pay for the discounted future cash flows of a company. Investors take risk when they see that their expected returns matching with the return from an investment they make. Here, capital asset pricing model or CAPM helps the investors in getting an idea of required return on an investment.
Best proxy for:
(1) the risk-free rate: Domestically held long term government
bonds are the best proxy for risk free rates.
Example: In the U.S., long term treasury coupon bonds.
(2) the market rate of return: Return on the domestic stock markets
indices are the best proxy for market rate of return.
Example: In the U.S., S&P 500 index.