Question

Explain why following statement is not correct: “The higher the risk of my portfolio, the higher the expected return I should get. Otherwise nobody will take any risks.” Use CAPM formula to help you understand.

Answer 1

The CAPM formula is required return = risk free rate + beta× market risk premium

So lets say an investor has two options, one to invest in risk free securities which have lesser retun and less risk and second to invest in the market with higher return and risk securities like equity.

One gets a premium to invest in equities in the form of market risk premium which is the return on market less the risk free rate but that is dependent on the value of beta, which is the elasticity to which how equity return reacts to market.

So if you want to take less risk invest in risk free securities but if you want to take high risk invest in equity and earn higher return

I hope this helps

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