Question

In regards to the CAPM pricing model, what happens if one variable is changed? What way does the risk premium, risk free rate, and beta move? Explain why.

Answer 1

CAPM is given by: cost of equity = risk-free rate + beta*(market return - risk-free rate)

If any of the variables are changed in the CAPM equation, the cost of equity will also change.If beta increases, then cost of equity increases and if beta decreases, cost of equity decreases. Similarly, if market return increase, the required risk premium for the equity increases and so, cost of equity increases. It will decrease if market return decreases. For risk-free rate, the change in cost of equity depends upon the beta.If beta is less than one, then if risk-free rate increases, the cost of equity will increase. However, if beta is more than one, then if risk-free rate increases, then cost of equity will decrease.

If risk premium increases, it means that investors are demanding more return to cover for the extra risk so it is to be expected that the cost of equity will go up. If beta is more than one, it implies that the stock is more volatile as compared to the market and again, investors will demand more return to compensate for the volatility. Similarly, if the risk-free rate increases or decreases,it implies that overall, the market expectation has moved up or down so the CAPM will incorporate the same. Investors demand a return which is higher than the risk-free rate to compensate for the extra risk of the stock so if risk-free rate goes up, the cost of equity has to go up and vice-versa.