## 6 Questions

What is the CAPM formula for calculating a portfolio's required return?

RF + (RM - RF)

What does the beta (βP) measure?

The measure of a security or portfolio's risk relative to the market volatility (σM)

What is the relationship between risk and return in the CAPM model?

The CAPM model specifies a linear relationship between risk and return

What is the relationship between the required return (R) and price in the dividend discount model?

As R increases, price decreases

What does the market risk premium (MRP) represent in the CAPM formula?

The MRP represents the incremental return above the risk-free rate of return

What is the relationship between beta (βP) and systematic risk in the CAPM model?

Beta represents the risk of a security or portfolio relative to the market/system in the CAPM model

## Study Notes

Understanding the Capital Asset Pricing Model (CAPM)

- The CAPM provides a discount rate (R or k) based on the amount of systematic or market risk a portfolio represents.
- The model specifies a linear relationship between risk and return, assuming investor rationality and market efficiency.
- The return (R) is the discount rate (k) used in Capital Budgeting, and is the economic cost to the corporation.
- The CAPM formula calculates a portfolio's required or expected return (RP) as the risk-free rate of interest (RF) plus a risk premium (RM - RF) multiplied by the portfolio's beta (βP).
- RP represents the investor's required return, which they would not accept less than in an efficient market.
- The required return (R) is used as the discount rate in the dividend discount model, and as R increases, price decreases.
- The risk-free rate (RF) is the CAPM's vertical intercept and has no risk but provides some positive return.
- The market risk premium (MRP) is the incremental return above the risk-free rate of return and corresponds to the market's risk-level.
- RM - RF is the MRP and represents the incremental return awarded to investors for taking on any risk greater than zero.
- Beta (βP) is the measure of a security or portfolio's risk relative to the market volatility (σM).
- Beta represents systematic risk, or the risk of a security or portfolio relative to the market/system.
- Risk is the extent to which the return actually earned differs from the expected return, and is measured by the standard deviation of return.

Understanding the Capital Asset Pricing Model (CAPM)

- The CAPM provides a discount rate (R or k) based on the amount of systematic or market risk a portfolio represents.
- The model specifies a linear relationship between risk and return, assuming investor rationality and market efficiency.
- The return (R) is the discount rate (k) used in Capital Budgeting, and is the economic cost to the corporation.
- The CAPM formula calculates a portfolio's required or expected return (RP) as the risk-free rate of interest (RF) plus a risk premium (RM - RF) multiplied by the portfolio's beta (βP).
- RP represents the investor's required return, which they would not accept less than in an efficient market.
- The required return (R) is used as the discount rate in the dividend discount model, and as R increases, price decreases.
- The risk-free rate (RF) is the CAPM's vertical intercept and has no risk but provides some positive return.
- The market risk premium (MRP) is the incremental return above the risk-free rate of return and corresponds to the market's risk-level.
- RM - RF is the MRP and represents the incremental return awarded to investors for taking on any risk greater than zero.
- Beta (βP) is the measure of a security or portfolio's risk relative to the market volatility (σM).
- Beta represents systematic risk, or the risk of a security or portfolio relative to the market/system.
- Risk is the extent to which the return actually earned differs from the expected return, and is measured by the standard deviation of return.

Test your knowledge of the Capital Asset Pricing Model (CAPM) with this quiz! Learn about the model's key concepts, such as risk and return, beta, and the market risk premium. See if you can calculate a portfolio's expected return using the CAPM formula and understand the importance of the discount rate in capital budgeting. Challenge yourself and see how well you understand this important financial concept.

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