Question

9. According to the capital asset pricing model (CAPM), where does an asset’s expected return come from? Please explain each component.

Answer 1

As per CAPM, Expected Return of an asset is derived from the following equation :-

Expected Return = Risk-free rate of return + Beta of the Asset * ( Market Risk Premium)

Risk-free rate of return = This is the rate offered by T-bills / Treasury bonds and represents the rate of return offered by investing in Government securities / bonds which carry no risk. The risk-free rate should correspond to the country where the investment is being made.

Beta of the Asset = Beta represents the riskiness of the asset. Beta is a measure of a stock’s risk (volatility of returns) reflected by measuring the fluctuation of its price changes relative to the overall market. For instance, if a company’s beta is equal to 1.5 the security has 150% of the volatility of the market average.

Market Risk Premium = The market risk premium represents the additional return over and above the risk-free rate. This is required to compensate investors for investing in a riskier asset class.