Ok, I don’t know how this has happened, but with just 1.5 months to go before CFA L2 in May, I’ve only just discovered that there’s a difference between CAPM when you have a market risk premium and equity risk premium.
Is it only the former that holds in equilibrium? So using a market risk premium is only really theoretical measure of systematic risk, and you use required return ERP when valuing a particular stock?
I’ve got a bit confused about this after doing a Schweser mock with a question that only had the market risk premium and not the equity required return
The difference between market risk premium vs equity risk premium is a matter of scope:
- Market risk premium represents the additional expected return of the index, market or investment portfolio as a whole, above risk free rate.
- Equity risk premium represents the additional expected return of equity, or single stock, above risk free rate.
Capital Asset Pricing Model (CAPM) is a model for pricing an individual security or portfolio, with the formula:
E(Ri) = Rf + βi (E(Rm) – Rf)
where E(Ri) is the expected return on capital asset and E(Rm) is the market risk premium.
It would depend on the question, but typically CAPM does not use the equity risk premium of a particular stock in place of market risk premium. The beta (βi) is the one that conveys the sensitivity of the expected excess return of the valued asset in relation to the expected excess return of the market.
If you’ve seen a CAPM example that uses ‘equity risk premium’ instead of ‘market risk premium’, maybe they were using this interchangeably to mean ‘equity’ as in ‘equity market as a whole’, since the ‘market’ in market risk is usually an equity market. Or else I’d be interested to see their explanation.
Does that answer your question?
So using a market risk premium is only really theoretical measure of systematic risk, and you use required return ERP when valuing a particular stock?
Also slightly confused by the above statement. The CAPM model is a method of determining required return on equity E(Ri) using market risk premium E(Rm) and beta of the asset.
You are given the following information about corporate stock P and the market: Risk-free rate is 7
The expected return and volatility for corporate stock P is 7 and 33 respectively.
The Expected Return and Volatility for Market is 6 and 12 respectively.
The correlation between the returns of corporate stock P and the market is 18. Assume the Capital Asset Pricing Model holds. Calculate the required return for corporate stock P? Could somebody solve this question?
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