Unformatted text preview: • What goes into the NPV formula is the expected
return, not any of the other 2. • The risk premium refers to the extrareturn awarded
for holding undiversiﬁable risk. • Default risk and diversiﬁable risk are very important
for the NPV formula, but only when you are computing expected cash ﬂows (numerator), not expected
returns (denominator). • When computing actual (expost, observable) returns,
whether there is default or not, and what realization
of the random process for cash ﬂows you got are, of
course, tremendously important. 2 Inputs in the CAPM formula
E (ri) = rF + β i[E (rm) − rF ] 2.1 Riskfree rate • In empirical applications use the interest rate from
Treasury bills with comparable horizon as the returns
under study. Why Tbills? Presumably, no default
risk, no liquidity risk, no risk premium...as close as
it is going to get to time premium. • The CAPM is truly a oneperiod model, so there isn’t
really a concept of diﬀerent riskfree rates based on
diﬀerent horizons. 2.2 Beta • Huge problem: beta is forward looking and we only
have historical data. As we said bef...
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 Fall '08
 FranciscoDeBorjaLarrain
 Capital Asset Pricing Model, CAPM formula

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