Question

Discuss how the capital asset pricing model CAPM rewards shareholders for risk.

Answer 1

CAPM model:

Re = Rf + beta (Rm - Rf)

Here, beta signifies the systematic risk, that an investor is exposed to in a particular stock, which cannot be diversified away and which moves with the market. So, higher the risk, higher will be the beta of the security.

The beta is higher, then the equity risk premium which is the compensation to the investor, for taking higher levels of risk rises.

Assets with higher risks, demand a higher expected return. The risk free rate, is the compensation to the investor for the time value of money .

The CAPM basically explains to us through the equation that, the investor demand a higher required return if the asset has a higher risk.