From the course: Finance Foundations
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Capital asset pricing model (CAPM)
- Alright, we've introduced all the pieces. We are now ready to look at the entire capital asset pricing model. Remember, the risk-free rate is the minimum return that we have to earn on any investment. Returns on investments in the stocks of companies have to be higher than the risk-free rate. We call that difference the equity-risk premium. Alright, so how much higher? Well that depends on the risk associated with the investment, and remember that this is unavoidable risk, or beta risk. Some risk can be avoided through diversification, but the beta risk cannot be avoided through diversification because it relates the overall movements in the economy. Let's see how the capital asset pricing model works with some numbers. Let's use Ford Motor Company to start. Remember, if you want to induce me to invest in Ford Motor Company, you have to at least make me think that I'm going to earn the risk-free rate of 5%. In addition there needs to be an equity risk premium, we'll start with the…
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