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Explain the Capital Asset Pricing Model, and each component of the calculation. Provide your own calculation...

Explain the Capital Asset Pricing Model, and each component of the calculation. Provide your own calculation and explain it step-by-step. How does the CAPM account for risk and the time value of money?

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Answer #1

Capital Asset Pricing Model, CAPM estimates the required return on the stock based on the systematic risk, beta of the stock. The equation is given below:

Let's calculate the required return on the stock which has a beta of 1.2

The return on the market is 12% and the risk-free rate is 3%

The required return on the stock is 13.8%

The CAPM accounts only for the non-diversifiable risk (market risk) by providing a risk premium (rm - rf) and it is weighted by beta. The term beta*(rm - rf)defines this risk.

The time value of money is accounted for by the risk free rate rf.

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