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Explain the capital asset pricing model. Make sure to explain the importance of beta.

Explain the capital asset pricing model. Make sure to explain the importance of beta.
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Answer #1

Capital asset pricing model is used to calculate cost of equity which is dependent on risk free rate, beta and market risk premium. It is one of the best methods to calculate cost of equity. Risk free rate can be obtained from 10 year US government bond. Market return can be obtained by average returns of market over a period of time.
Cost of equity = Risk free rate + Beta * (Market return – Risk free rate)

Beta is the measure of systematic risk in a portfolio which can be calculated by estimating the covariance of market return and portfolio return by variance of market. Higher the beta the market returns will be more related o markets returns (beta>1). For Beta =0 the portfolio return is indifferent to market return and Beta<0 the return of portfolio will be in opposite direction to the market return.

Best of Luck. God Bless

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