We will see a few examples of CAPM, which is most often used to determine an investment’s fair price. If the Beta is -1, then it means the stock prices are less risky and volatile. If the Beta equals 1, then the expected return on investment equals the market average return. For example, if a company’s Beta is equal to 1.7, it means it has 170% of the volatility of returns of the market average, and the stock price movements will be rather extreme. It calculates the investment’s volatility. The CAPM formula represents Beta as “Ba,” demonstrating how much a security or portfolio’s price fluctuates compared to the overall market’s return. Typically, when estimating the risk premium, one determines the risk-free rate of return by taking the average of historical risk-free rates of return rather than relying on the current risk-free rate of return. When planning an investment, it is crucial to consider the risk-free rate of the country where you intend to invest and align the maturity period of the bond with your investment timeline. The risk-free rate is the return that an investment earns no risk, but in the real world, it includes inflation risk. The “Rrf” denotes the risk-free rate, which is equal to the yield on a 10-year US Treasury bill or government bond. The “Ra” refers to the expected return of an investment over a period of time. For example, the US treasury bills and bonds are used for the risk-free rate. To estimate the market rate of return, Rm, one can rely on past returns or project future returns. Therefore, the expected return on the market and the risk-free rate differ. Investors expect a higher reward, known as the market risk premium, to compensate for the risk inherent in investing in the stock market compared to investing in government bonds.
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