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Unformatted text preview: required for the project's market risk Capital budgeting & risk, a reading prepared by Pamela Peterson Drake 11 Now let's explain how to determine the premium for bearing market risk. We do this by first specifying
the premium for bearing the average amount of risk for the market as a whole and then, using our
measure of market risk, fine tune this to reflect the market risk of the asset. The market risk premium
for the market as a whole is the difference between the average expected market return, rm, and the
risk-free rate of interest, rf. If you bought an asset whose market risk was the same as that as the
market as a whole, you would expect a return of rm - rf to compensate you for market risk.
Next, let's adjust this market risk premium for the market risk of the particular project by multiplying it by
that project's asset beta, βasset:
Compensation for market risk = β asset (rm - rf).
β This is the extra return necessary to compensate for the project's market risk. The asset beta fine-tunes
the risk premium for the market as a whole to reflect the market risk of the particular project....
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- Spring '07