CAPM Simplified

The capital asset pricing model is the model that suggests that a stocks required return is equal to the risk free rate plus a risk premium that reflects the riskiness of a stock after diversification.  The risk free rate refers to the rate of return which bring no risk with it, such as the US treasury bond.  The risk premium portion of this formula refers to the rate of return difference between a risk free asset and a stock market benchmark such as the S&P 500.  Therefore, you can see how a fund manager, investing in assets which are not risk free, should be at least making the risk free rate plus the market risk premium.

If the investment manager invests in individual stocks, this market risk premium should be multiplied by the beta of the investment.  Therefore, the investment manager should at least be producing the risk free return + beta *(market risk premium).  This result equals the required return on equity and investors will demand at least this much return for the risk that was taken.


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