Risk Premium and Risk Return in Capital Markets

1. In the capital market line, investors calculate the risk premium associated with a portfolio of specific stocks. The expected return of the portfolio is equal to the risk free interest rate plus a risk premium multiplied by the portfolio's standard deviation. The risk premium is equal to the expected market returns minus the risk-free return divided by the standard deviation of the market. Key to this approach is the emphasis on the market's performance and the risk associated with the market, as well as the portfolio's performance and the risk associated with the portfolio. Individual securities are not taken into account specifically, but the portfolio and market as a whole--and their associated risks--are evaluated, instead.

The security market line, as its name suggests, is concerned with individual securities. In the case of an individual security, risk is associated with how the security varies in relationship to the market as a whole. Here, covariance is used instead of the standard deviation since the risk of an individual security is measured by its contribution to the risk of its associated portfolio. The security market line also uses the covariance of the market, rather than the standard deviation used with the capital market line. Risk is thus measured by the covariance of each security against the market, and the scale is considerably smaller than the scale of the capital market line. A security that has zero correlation to the market is riskless wh



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Category: Economics - R
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