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Expected
return is the return that you as an investor expect to receive in
compensation for putting money into a particular investment. An investor expects
a return in proportion to the degree of risk of a given investment. The higher
the risk, the higher the expected return.
Beta is the measure of a stock's systematic or
market risk. In other words, it measures the degree to which a stock fluctuates
in relation to the overall market. The overall market has a beta of 1. Any stock
that is more volatile than the overall market will have a beta greater than 1,
which means it is riskier than the market. A stock that has a beta less than 1
is less volatile than the market and less risky. You can find the beta of any
publicly traded company in a beta book.
The risk-free rate is the rate of return on an
asset that has zero risk. Generally, U.S. Government securities are used to
approximate the risk-free rate because they have no default risk.
Risk premium is the rate of return of the market
in excess of the risk-free rate. This excess return is compensation for taking
on additional risk. The risk premium is calculated by subtracting the risk-free
rate from the expected market rate of return:
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