(^68) Financial Management
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Investors can earn a riskless rate of return by investing in riskless assets like treasury
bills. This risk free rate of return is designated Rf and the minimum return expected by
the investors. In addition to this, because investors are risk-averse, they will expect a
risk premium to compensate them for the additional risk assumed in investing in a risky
asset.
Required Rate of Return = Risk-free rate + Risk premium
The CAPM provides an explicit measure of the risk premium. It is the product of the
Beta for a particular security j and the market risk premium Km - Rf.
Risk premium = bj (Km-Rf)
This Beta co-efficient 'bj' is the non-diversifiable risk of the asset relative to the risk of
the market. If the risk of the asset is greater than the market risk, i.e., b exceeds 1.0,
the investor assigns a higher risk premium to asset j, than to the market.
The Security Market Line
The plot of relationship between the required rate of return (kj) and non-diversifiable
risk(beta) as expressed in CAPM will produce a graph of the SML as shown below
As per the CAPM assumptions any individual security's expected return and beta
statistics should lie on the SML. The SML intersects the vertical axis at the risk-free
frankie
(Frankie)
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