RELATIONSHIP BETWEEN RISK AND RATE OF RETURN

The CAPM expresses risk-return relationships using beta as the relevant risk
measure. CAPM states that the required rate of return on a risky asset consists of
the risk-free rate plus a premium for systematic risk. The formula for the capital
asset pricing model is:

ri = rf + bi (rm-rf)
where:

ri = required (or expected) return on security, i

rf = expected risk-free rate of return

rm = expected return on the market portfolio

bi = beta coefficient of security, i

1. The risk-fee rate of return (rf), is the return required on a security having no
systematic risk and is generally measured by the yield on short-term
Treasury securities such as Treasury bills.

(a) The risk-free rate consists of two components: a real rate that
excludes any inflationary expectations, and an inflation premium that
equals the expected inflationary rate.

(b) The risk-free rate changes in the same direction and by the same
amount as the inflation premium changes. Since the risk-free rate is
part of a security’s required rate of return, a change in inflationary
expectations will also increase the required return on all securities (rm).

2. The risk-premium, bi (rm-rf), is the return required in excess of the risk-free

rate and is due to systematic risk. Part of the risk premium is the market risk
premium (rm-rf), which is the additional return expected for holding a
market portfolio of “average” riskiness (b = 1.0). The risk premium for a
specific security will differ from the market risk premium if the individual
security’s beta does not equal to 1.0. .
Illustrative Case 23-4. Determination of Portfolio Required Rate of Return Using
CAPM Approach.

For example, the betas of Stock 1 and Stock 2 are 2.0 and 0.5, respectively. The
risk-free rate is 8 percent and the expected return on the market is 14 percent.
Using the equation for CAPM, the required rates of return and risk premiums are:

Stock 1 Stock2

r1= 0.08 +(2.0) (0.14-0.08) r2 = 0 08 +(0. 5) (0. 14 -.008)

=0.08+0.12 =0.08+0.0.

=0.20 or 20% =0.11 or 11%

Stock 1 requires a 20 percent return and has a high risk premium of 12 percent.
Stock 2 requires an 11 percent return and has a low risk premium of 3 percent.
The risk premiums are high or low relative to the market risk premium of 6 percent
(14 percent - 8 percent), which represents the risk premium on average risk
stocks.