Concept of Capital Asset Pricing Model (CAPM)
Globally investment in Government securities is considered to be “risk free” investment. We may not agree with the statement that they are totally risk-free. In the absence of any better alternative that is 100% risk free, this has been accepted as “risk-free” investment. Suppose the average return from investment in Govt. securities in India say, is 6.5% p.a. Risk-averse investors would be induced to invest in market securities like shares or debentures or bonds only when they get what is known as “risk premium”. Let us assume this to be 6%. This means that the market investment should fetch us 6.5% + 6% = 12.5%. Unless we are sure of this return we will not invest in market securities.
Is there any readymade portfolio whose return represents the market return?
Yes. The BSE sensex represents the market portfolio and the return on this for a given period is the market rate of return. The difference between this market rate of return (12.5%) and risk free rate (6.5%) represents the market premium (6%). Is BSE sensex the only portfolio? No. NSE’s 50 stock index is another one. However let us bear in mind that BSE sensex or NIFTY FIFTY does not include any debt instrument like debenture or bond or short-term money market instruments. Hence the parameter of market premium as applicable to BSE sensex etc. relates only to investment in equity shares.
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