CALCULATING EXPECTED RETURNS USING THE CAPITAL ASSET PRICING MODEL
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If you invest in Microsoft, what return do you
expect on your investment?? 8 percent? 12 percent? 20 percent?? Would you expect
different returns on the same investment in AT&T?? You should, because investments
in these companies don?t involve the same degree of risk.? The CAPM provides an
easy-to-use formula for calculating expected returns on individual stocks based
upon their risk:?
is the expected return on stock i?
rf is the current risk-free rate (the rate of return on investments
with virtually no risk, such as U.S. Treasury bills)
is the beta for firm i?
is the expected return on the overall market
Suppose a technology company called Risky.com
has a beta of 2, the expected return on the market is 10 percent, and the current
risk-free rate is 5 percent.? What is the expected return on an investment in
Risky.com?? Plugging these numbers into the formula, we find that we should
expect a return of 15 percent for Risky.com.?
You now have an introduction to a concept
that has helped many people achieve their financial goals.