Question
In the CAPM model, the expected return is expressed
as: E(R)=Rf+β(Rm−Rf) Here, what does the risk-free rate (Rₓ) represent or compensate the investor for?Solution
• In the Capital Asset Pricing Model (CAPM), the risk-free rate (Rₓ) is the minimum return an investor expects for providing capital without assuming any additional risk. • It compensates only for the time value of money—the idea that money available today is worth more than the same amount in the future due to its earning potential. • The risk premium [β(Rm – Rf)] compensates for the systematic risk (market risk) associated with the investment. • In practice, a true risk-free asset does not exist, but long-term government securities (like the 10-year G-sec in India) are used as proxies.
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