Question

1) Do projects that add more risk to our portfolio need to provide more reward? Do projects that have high variance need to provide more reward? What asset has a beta of zero? What is the appropriate market rate of return for such a security?

2) Does CAPM takes care of default risk? Does the use of CAPM E(r) in the NPV formula takes care of the default risk?

3) What are the CAPM inputs? How would you estimate them? What is the appropriate risk-free rate in CAPM? Note: E(r) is expected return.

Answer 1

1. Risk and reward are directly related. The higher the risk, higher is the reward that is expected out of the portfolio. A high variance portfolio is to mean that the expected return and the standard return vary by quite a large value. Hence, in this case the risk is high which translates in to higher reward expectancy. A asset that is not susceptible to changes in the market conditions has a beta of zero. A risk free rate of return is appropriate for such security.

2. CAPM does not take in to account default risk. You must use default risk in the numerator of the NPV formula, and use CAPM E(r) on the denominator.

3. CAPM inputs are risk free rate of return, beta of the security and risk premium. Risk free rate of return is usually taken from the treasury bonds return, beta is the volatility of the stock and risk premium is the prevailing market return on return minus the risk free rate of return.