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
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