Is the CAPM able to explain the changes in required return d

Is the CAPM able to explain the changes in required return due to changes in 1) risk-free rate 2) risk aversion 3) Beta? Explain

Solution

Capital Assets pricing model

Capital Assets pricing model is the method uses to determine required rate of return of an asset. This method uses, Risk free rate, market return and beta (a measure of market risk) to determine required rate of return on an asset. Market risk premium is calculated by market return and risk-free rate.

Beta is a measure of level of risk in investment. when beta of the company is changed that is level of risk change then the cost of capital of company is also change.

Capital assets pricing model formula for calculation of cost of capital is mention below:

Required rate of return = Risk free rate + (Market Return - Risk free rate) × Beta

1. If risk free rate change then required rate of return will also chane, because risk free rate and required rate of return is directly related.

2. Risk aversion (risk premium) is also directly related to required rate of return, so if risk aversion changes then required rate of return will also chnages.

3. beta is a measure of risk. as beta chnages then level of risk in investment changes. Asgain, if level of risk chnages then required rate of return changes.