In finance, E(rm) represents the average return on the capital market. It's often used in models like the Capital Asset Pricing Model (CAPM).
In simpler terms, E(rm) is what investors expect to earn, on average, by investing in the overall market (e.g., a broad market index like the S&P 500). This expected return is a crucial input for determining the required rate of return for an individual asset.
Here's a breakdown of why it's important:
- Benchmarking: It provides a benchmark against which to measure the performance of individual investments.
- Risk Assessment: The difference between the expected return of an individual asset and E(rm) reflects the asset's specific risk.
- Capital Allocation: Investors use E(rm) to make informed decisions about how to allocate their capital across different asset classes.
CAPM Formula & E(rm)'s Role
The Capital Asset Pricing Model (CAPM) uses E(rm) to calculate the expected return on an asset, considering its risk relative to the market. The CAPM formula is:
Expected Return = Risk-Free Rate + Beta * (E(rm) - Risk-Free Rate)
Where:
- Risk-Free Rate: The return on a risk-free investment (e.g., a U.S. Treasury bond).
- Beta: A measure of an asset's volatility relative to the market.
- E(rm): Expected return on the capital market (as stated above).
- E(rm) - Risk-Free Rate: This is the market risk premium – the additional return investors expect for taking on the risk of investing in the market rather than a risk-free asset.
Example:
Imagine the risk-free rate is 3%, E(rm) is 10%, and an asset's beta is 1.2. Then, the expected return on the asset would be:
3% + 1.2 (10% - 3%) = 3% + 1.2 7% = 3% + 8.4% = 11.4%
This means investors would expect a return of 11.4% on this asset, given its risk relative to the overall market.
