Question

In CAPM how do changes in the risk free rate affect investor utility?

Answer 1

The risk free rate is the rate at which an identical market rate for the security at which the investor will not incur any financial loss. Risk free rate of interest is of great significance in CAPM since the slightest increase/ decrease can change the expected market return on the security.

Example:

CAPM= Risk free rate + Beta * Market Premium

Situation 1: Risk free rate= 5% ,Beta=0.5, Market premium= 8%

Expected return= 5%+0.5*8% = 9%

Situation 2: Lets assume the risk free rate was wrongly taken as 3%. Other values are same.

Expected return= 3% + 0.5*8%= 7%

In the above example, a change in risk free rate of return has reduced the expected return on the security. A security with lesser expecte rate of return than the risk free rate will sell for a lesser price and vice versa.