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Introduction
The Capital Asset Pricing Model (CAPM) is a model that shows the relationship between the return and risk of investing in stocks and other securities. The return on securities using this formula is equal to the risk return plus the risk premium (Ayub et al., 2020).
Discussion
The risk premium is determined using the beta (Ayub et al., 2020). CAPMs expected return shows how the assets will pay off in the long run. Beta CAPM shows the volatility of a stock, that is, its price changes in relation to the market (Ayub et al., 2020). Knowing the CAMP formula helps investors assess whether the current price of a security is in line with the stated yield. To do this, an investor needs to know the main variables the expected return for the market and risk-free asset and beta. CAMP has limitations in usage due to the linear interpretation of risk and return.
Risk Premiums
Risk premiums are income paid to an investor for taking on additional risk as compensation. When calculating it, the expected return on investment is compared with a risk-free interest rate, for example, with a yield on US Treasury bonds of 3.25% (Li & Zinna, 2018). The level of risk an investor is willing to accept depends on their investment goals, so risk and returns can rarely be determined. The risk premium is the amount at which the expected return on a risky asset must exceed the risk-free return to make risky and risk-free assets equally attractive (Li & Zinna, 2018).
Conclusion
Thus, investors decisions will be influenced by whether they are willing to risk their investments for the sake of possible profit or whether they want to receive a stable, predictable income.
References
Ayub, U., Kausar, S., Noreen, U., Zakaria, M., & Jadoon, I. A. (2020). Downside risk-based six-factor capital asset pricing model (CAPM): A new paradigm in asset pricing. Sustainability, 12(17), 6756. Web.
Li, J., & Zinna, G. (2018). The variance risk premium: Components, term structures, and stock return predictability. Journal of Business & Economic Statistics, 36(3), 411-425. Web.
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