When calulating CAPM the examples in the text book material seem to differ between using;
= Rf + Bi [E(Rm) - Rf] and = Rf + Bi[E(Rm)]
I do not understand why the reason why the calulation sometimes uses only the market risk premium and other times uses the difference between the market risk premium and the risk free interest rate.
Any help on clearing up this matter would be greatly appreciated?
According to the CAPM the expected return to a risky asset is the sum of the risk free rate (the return any investor would expect to earn with zero risk) and a risk premium to compensate for the stock’s exposure to the market ( here we are talking about risk that cannot be diversified away by holding a diversified portfolio).
- market risk premium = E(Rmarket) - rf
- risk premium = Bi*(Market Risk Premium)=Bi*(E(Rmarket)-rf)
So when the book mentions ‘market risk premium’ it is talking about the difference between the expected market return and the risk free rate. The market risk premium IS the difference, so there are no contradictions there!
Hope this helps and happy exams!
Thanks, i’ve just been over some practice questions on this and I now fully understand it, thanks for clearing that up for me