56 capital assets pricing model capm the capital

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Unformatted text preview: k-free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are superior to those on the efficient frontier. 5.6 Capital assets pricing model (CAPM) The Capital Assets Pricing Model (CAPM) derives the expected return on an assets in a market, given the risk-free rate available to investors and the compensation for market risk. CAPM specifies that the expected return on an asset is a linear function of its beta and the market risk premium: (32) Expected return on stock i ri r f  E i (rm  r f ) Where rf is the risk-free rate, i is stock i's sensitivity to movements in the overall stock market, whereas (r m - r f ) is the market risk premium per unit of risk. Thus, the expected return is equal to the risk free-rate plus compensation for the exposure to market risk. As i is measuring stock i's exposure to market risk in units of risk, and the market risk premium is the compensations to investors per unit of risk, the compensation for market risk of stock i is equal to the i (r m - r f ). Download free ebooks at bookboon.com 38 Corporate Finance Risk, return and opportunity cost of capital Figure 6 illustrates...
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