What is the relationship between the market risk of a security and the rate of return that investors demand of that security?

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What is the relationship between the market risk of a security and the rate of return that investors demand of that security?




Answer: The extra return that investors require for taking risk is known as the risk premium. The Canadian MARKET RISK PREMIUM - that is, the risk premium on the MARKET PORTFOLIO - averaged 7 percent between 1926 and 2010. The CAPITAL ASSET PRICING MODEL states that the expected risk premium of an investment should be proportional to both its beta and the market risk premium. The expected rate of return from any investment is equal to the risk-free interest rate plus the risk premium, so the CAPM boils down to

r = rf + B(rm - rf)

The SECURITY MARKET LINE is the graphical representation of the CAPM equation. The security market line relates the expected return investors demand of a security to the beta.

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