Chartered Financial Analyst (CFA) Practice Exam Level 2

In CAPM, what does 'Rf' represent?

1. Rate of return on the market

2. Risk-free rate of return

3. Equity risk premium

4. Average return of risky assets

The correct answer is: Risk-free rate of return

In the Capital Asset Pricing Model (CAPM), 'Rf' denotes the risk-free rate of return. This is a foundational component of the model, as it represents the return expected from an investment with zero risk, typically associated with government securities such as Treasury bills. The risk-free rate serves as a benchmark for evaluating the additional returns that investors require for taking on extra risk through investing in riskier assets, such as stocks. By using the risk-free rate, CAPM seeks to explain the relationship between systematic risk (market risk, represented by beta) and expected return on an asset. Investors use 'Rf' to determine the excess return needed for assuming additional risk beyond that of risk-free investments, which is a key aspect when pricing securities and assessing investment opportunities. Understanding this concept is crucial for analyzing and applying the CAPM framework effectively in asset pricing and investment decisions.