According to the CAPM, what is the rate of return of a portfolio with a beta of 1?
a. Between Rm and Rf
b. The risk-free rate, Rf
c. Beta * (Rm – Rf)
d. The return on the market, Rm
Answers
Answer:
Although the concepts of the CAPM can appear complex, the application of the model is straightforward. Consider the following information:
Risk-free rate of return = 4%
Equity risk premium = 5%
Beta value of Ram Co = 1.2
Using the CAPM:
E(ri) = Rf + βi (E(rm) – Rf) = 4 + (1.2 x 5) = 10%
The CAPM predicts that the cost of equity of Ram Co is 10%. The same answer would have been found if the information had given the return on the market as 9%, rather than giving the equity risk premium as 5%.
Explanation:
The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk of the investment's return being different from the expected return. This minimum level of return is called the ‘risk-free rate of return’.
The formula for the CAPM, which is included in the formulae sheet, is as follows:
E(ri ) = Rf + βi(E(rm) – Rf)
E(ri) = return required on financial asset
Rf = risk-free rate of return
βi = beta value for financial asset
E(rm) = average return on the capital market
This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium – βi (E(rm) – Rf) – which compensates the investor for the systematic risk of the financial asset. If shares are being considered, E(rm) is the required return of equity investors, usually referred to as the ‘cost of equity’.
The formula is that of a straight line, y = a + bx, with βi as the independent variable, Rf as the intercept with the y axis, (E(r m ) – Rf) as the slope of the line, and E(ri) as the values being plotted on the straight line. The line itself is called the security market line (or SML), as shown in Figure 1.
In order to use the CAPM, investors need to have values for the variables contained in the model.