Week 5 Forum 1

Week 5 Forum 1
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Week 5 Forum 1
In the financial world, the Capital Asset Pricing Model (CAPM) is a model that shows the relationship between systematic risk and expected return for assets, especially stocks (Campbell, 1993).
We have three components that make up the expected returns, and they are as follow: Risk-free rate, Beta of the security and Expected market return.
Risk-free rate
The risk-free rate refers to the minimum return an individual should gain within a certain period of time when he makes any investment, which has zero risks. In reality, this cannot hold as there is no investment that has zero risks.
Many times, the risk-free rate is used as a benchmark by an investor in decision making. The interest of government bonds are the ones used as the risk-free rate. The bonds are considered to be safer to invest in as the government is unlikely to have insufficient funds to pay back.
Beta of the security
When an investor wants to make a decision on which stock to go for, then he uses beta (a numerical value) which show him stock that has more risk and highly correlated with the market. Therefore, beta measures how stock prices respond to the stock market.
In CAPM beta plays the role of measuring the volatility of the stock and the systematic risks occurring. A positive beta will depict that the stocks are moving in the direction of the market.
Expected market return
This is one of the variables that are used in the CAPM to ensure the accuracy of its results.

When an investor makes a forecast on the profit or loss that he is going to get, then this is referred to as expected return. Therefore, the accuracy of the CAPM depends on the ability of the investor to correctly forecast the expected market return for a specific period.
Reference
Campbell, J.Y. (1993). Understanding risk and return (No.w4554) National Bureau of Economic Research