According to the capital-asset pricing model (CAPM), a security’s expected (required) return is equal to the risk-free rate plus a premium
A. equal to the security’s beta.
B. based on the unsystematic risk of the security.
C. based on the total risk of the security.
D. based on the systematic risk of the security.
Answer Explanation for Question: According to the capital-asset pricing model (CAPM), a security’s expected (required) return is equal to the risk-free rate plus a premium
Capital Asset Pricing Model (CAPM) considers the relationship between the expected return and risk in investing in a security. Based on this model, the expected return on a security is equal to the risk-free return plus a risk premium determined by the beta of the security.
The formula for calculating the expected return of an asset given its risk is given below:
Expected Return = Risk free rate + (Beta x Market Risk Premium)
An investment’s “expected return” is a long-term assumption about the future performance of a long-term investment. There should be a risk-free rate that is appropriate for the country where the investment is being made, and the maturity of the bond should match the time horizon of the investment. The professional convention, however, is to always use the 10-year rate, since it is the most heavily quoted and liquid bond.
Beta (abbreviated “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of returns) expressed by the fluctuations of its price changes with respect to the overall market. Basically, it is the stock’s sensitivity to market risk. In the market risk premium, investors receive additional returns over and above the risk-free rate in order to compensate them for investing in a riskier asset class.