Page 150 - A Canuck's Guide to Financial Literacy 2020

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The model is based on systematic risk, also known as non-diversifiable risk. It mentions that
the expected return on a security is determined by taking the risk-free rate, usually the yield
on a government bond, plus a risk premium. The risk premium is the rate of return that is
greater than the risk-free rate. Investors who are looking to take above average risk needed
to be compensated in the form of a risk premium.

CAPM Formula

Re = Rf + βa ∗ (Rm − Rf)

Re = Expected return on a security
Rf = Risk-free rate
βa = Beta of the security
Rm = Expected return of the market (Rm−Rf) = market risk premium

The formula allows you to calculate the expected return on a security based on its level of
risk. The formula involves taking the risk-free rate plus the beta multiplied by the difference
between the rate of return on the market and the risk-free rate.

What is Beta?

Beta measures the systematic risk of an asset in relation to the over all movement of the
market. By definition, a beta is usually equal to 1. If the beta is lower than 1, this means that
the particular stock is a defensive stock and less volatile than its peers. If the beta is greater
than 1, this is a risky stock. Remember that systematic risk cannot be diversified away by
adding more uncorrelated securities to the portfolio.