The Capital Asset Pricing Model (CAPM) is a familiar term for finance analysts and CFA candidates. It is a model which helps approximate the required rate of return for a given investment portfolio based on it's systematic risk (unsystematic risk is assumed to be diversified away).
CAPM: E(R) = RFR + β(Market Premium)
Market Premium = E(R mkt) - RFR
∴E(R) = RFR + β [E(R mkt) - RFR]
Market Premium = E(R mkt) - RFR
∴E(R) = RFR + β [E(R mkt) - RFR]
Beta, β, describes the systematic risk and is equal to 1 at the market portfolio. Beta of stocks are described as systematic risk relative to the market portfolio.
While this is a fairly simple result, the implications are quite important. The expected return determines the cost of equity as well as the required rate of return. It also helps identify if stocks are over / under valued when we use the Security Market Line (next post).
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