The expected return on that stock per the CAPM is:Ģ% + 2(10%-2%) which simplifies to: 2% + 2(8%) which equals 18%. Suppose the risk-free rate of return is 2%, the return on the market as measured by the S&P 500 is 10%, and your stock has a beta of 2. Now, let’s put it all together in an example. If the market return is 10% and the risk-free rate of return is 2%, then 10%-2% is 8%, which is the market risk premium. We typically use the return on the S&P 500 as the “market” return. It’s simply the return on the market minus the risk-free rate of return. The part inside the parentheses is what we call the market risk premium. 5, then the stock is half as risky as the market. It’s a ratio, so if a stocks beta is 2 that means it is twice as risky as the market. The Greek letter beta represents the stock’s risk relative to the market as a whole. Kinda leaves a sour taste in your mouth doesn’t it? government’s ability to tax, there is virtually no chance they won’t be repaid. The idea is that since the interest and principal on a Treasury bond are backed by the U.S. Generally, the yield on a 6-month Treasury bond is how we estimate this, but you can use whichever maturity you think is appropriate. The risk-free rate is the rate of return you can expect to earn on a riskless investment. Here is what that means in plain English: This formula states that the expected return on a stock equals the risk-free rate plus the stocks beta times the return on the market minus the risk-free rate.
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