The market risk premium (also called equity risk premium) equals required return on the market (r m) minus the risk-free rate (r f) and the relationship between a stock’s risk and the market risk is given by the ratio of their mutual covariance to the ratio of variance of the market (σ m 2).
the market risk premium) and the extent to which the stock’s returns vary with the market.
#Capital asset pricing model equation plus#
FormulaĪn asset must earn at least as much as the risk-free rate plus a premium on account of the additional systematic risk which should equal the premium that a (theoretical) market portfolio earns in general (i.e. The basic logic behind the capital asset pricing model is that the required return on a stock should change in response to a change in systematic risk only.
Because unique risk can be reduced/eliminated through diversification, it need not be compensated through increased return. Risk in stock investments is broadly classified into systematic risk (also called undiversifiable risk) and unsystematic risk (also called unique risk or diversifiable risk). The article on capital allocation line offers how a portfolio of risk-free asset and a portfolio of risky assets interact with each other. You might want to review the article on risk and return to obtain an understanding of the portfolio expected return, standard deviation and their mutual trade-off on an efficient frontier. Where beta measures a stock’s exposure to systematic risk, the type of risk which can’t be diversified, and the equity risk premium is the additional return required on an average stock investment on top of the risk-free rate. Capital asset pricing model (CAPM) is a model which determines the minimum required return on a stock as equal to the risk-free rate plus the product of the stock’s beta coefficient and the equity risk premium.
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