What does Rf represent in CAPM?

What does Rf represent in CAPM?

• A. The return investors require for taking no risk, typically 10-year government bond yields
• B. The dividend yield of the stock
• C. The expected inflation rate
• D. The risk premium for equity

Answer: (A)

The concept at play is the risk-free rate. In CAPM, Rf is the return investors would expect from an asset with zero risk—the time value of money. It serves as the baseline, and the extra return for taking on risk is built on top of it. In practice, Rf is usually proxied by yields on long-term government bonds (like the 10-year Treasury) because they’re considered default-free and highly liquid, providing a reasonable benchmark for a riskless investment. In the CAPM formula, the expected return equals Rf plus the asset’s beta times the market risk premium (the difference between the expected market return and Rf), which shows how risk translates into additional expected return. It isn’t the dividend yield, nor the expected inflation rate, and while the market risk premium relates to equity, Rf itself is the baseline, not the premium.

The concept at play is the risk-free rate. In CAPM, Rf is the return investors would expect from an asset with zero risk—the time value of money. It serves as the baseline, and the extra return for taking on risk is built on top of it. In practice, Rf is usually proxied by yields on long-term government bonds (like the 10-year Treasury) because they’re considered default-free and highly liquid, providing a reasonable benchmark for a riskless investment. In the CAPM formula, the expected return equals Rf plus the asset’s beta times the market risk premium (the difference between the expected market return and Rf), which shows how risk translates into additional expected return. It isn’t the dividend yield, nor the expected inflation rate, and while the market risk premium relates to equity, Rf itself is the baseline, not the premium.