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    Question

    According to the CAPM model, Expected Return = Risk

    free rate + Risk premium. Here, what does the risk-free rate compensate the investor for?
    A The risk he undertakes Correct Answer Incorrect Answer
    B The time value of his money Correct Answer Incorrect Answer
    C Market volatility Correct Answer Incorrect Answer
    D A and B Correct Answer Incorrect Answer
    E B and C Correct Answer Incorrect Answer

    Solution

    The CAPM compensates investors for the time value of their money. In theory, the risk-free interest rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate. In practice, risk free rate does not exist because even the safest investments carry a very small amount of risk. However, the long-term G-sec rate is used as a proxy to risk-free rate of return (in India 10-year G-sec rate is used as risk free rate).

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