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  Monday November 20, 2017

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ELEMENTS OF THE CAPM
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There are four basic elements to the expected return/beta relationship that we calculated in the previous section. Let's break down each component:

Expected return is the return that you as an investor expect to receive in compensation for putting money into a particular investment. An investor expects a return in proportion to the degree of risk of a given investment. The higher the risk, the higher the expected return.

Beta is the measure of a stock's systematic or market risk. In other words, it measures the degree to which a stock fluctuates in relation to the overall market. The overall market has a beta of 1. Any stock that is more volatile than the overall market will have a beta greater than 1, which means it is riskier than the market. A stock that has a beta less than 1 is less volatile than the market and less risky. You can find the beta of any publicly traded company in a beta book.

The risk-free rate is the rate of return on an asset that has zero risk. Generally, U.S. Government securities are used to approximate the risk-free rate because they have no default risk.

Risk premium is the rate of return of the market in excess of the risk-free rate. This excess return is compensation for taking on additional risk. The risk premium is calculated by subtracting the risk-free rate from the expected market rate of return:

We will next see how the calculation is performed.




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