Equilibrium returns are determined using the Capital Asset Pricing Model (CAPM).

This model separates risk into systematic and idiosyncratic components. Systematic risk cannot be diversified away whereas idiosyncratic risk is diversifiable.

When markets are in equilibrium, CAPM assumes that investors are only compensated for systematic risk. They are not compensated for idiosyncratic risk. Rational investors should, therefore, diversify away all idiosyncratic risk.

The CAPM model assumes the existence of a market portfolio. This is typically approximated to consist of a basket of large stock and bond indices.

This expected return of an asset using the CAPM is a function of the assetâ€™s sensitivity to the market portfolio, the expected return of the market and the expected return of a risk-free asset.

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Category:Understanding the Software -> Return Estimation

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