CAPM: Risk Premium, Beta, and Required Return

All flashcards

Risk-free rate

A benchmark return assumed to involve negligible risk over the relevant period; U.S. Treasury securities are commonly used as a practical proxy.

Risk premium

The extra return expected for bearing risk, calculated as the risky investment’s return minus the risk-free rate.

Systematic risk

Risk associated with broad market movements that diversification cannot eliminate completely.

Beta

A measure of how sensitively a security tends to move in relation to the market.

Capital Asset Pricing Model (CAPM)

A model for estimating a security’s required return: $R_e = R_f + \beta(R_m - R_f)$.

Quiz questions

1. Which type of risk does CAPM focus on because investors can diversify away much of firm-specific risk?Answer: Systematic risk associated with broad market movements.
2. If a security has a beta of 0.5, what movement does it tend to make when the market rises by 8%?Answer: An increase of approximately 4%, in the same direction.
3. When a regression relates a stock’s returns to market returns, what does the fitted line’s slope estimate?Answer: The stock’s beta, or sensitivity to market movements.
4. Using CAPM with a risk-free rate of 3%, an expected market return of 9%, and beta of 1.2, what is the estimated required return?Answer: 10.2%.
5. Why can beta estimates from different data providers differ?Answer: Providers may use different historical periods, return intervals, or market benchmarks.