Practice Quiz

FRM Financial Risk Manager Practice Test

Category - The Capital Asset Pricing Model

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According to the CAPM model: Expected Return = Risk free rate + Risk premium. For investors like David, the model compensates the time value of his money and risk when he invests into any investment over a period of time. What does the risk free rate compensate David for?
  1. The time value of his money.
  2. The risk he takes.
  3. Both the time value of his money and the risk he takes.
  4. None
Explanation
The CAPM compensates investors for the time value of their money. In theory, the risk free interest rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate.

Key Takeaway: In practice, risk free rate does not exist because even the safest investments carry a very small amount of risk. Therefore, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.
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