Many people say that rM is the (stock or equity) Market expected return, and that this is the reason that to estimate it we consider stock indices like the S&P500 in the USA or the EuroStoxx50 for the Euro Zone as proxies for the Market. However, in the original CAPM model, rM represents a very specific investment called the Market Portfolio. However, the Market Portfolio is a theoretical portfolio of financial investments that unfortunate is impossible to determine in practice. This is the reason that we replace this Market Portfolio with a well diversified portfolio like a stock index like those emntioned. After this long preamble, here is the question. I would like some of you, probably those that have learned Finance before, to tell us in ways that we can understand what is this theoretical portfolio and why it is so important? Hint: Google ” Harry Markowitz” who is the guy who developed the theory behind such portfolio.
When we try to estimate the expected rM – rF, a) do we estimate the expected rM and then subtract the rF which we found as the first term of the CAPM formula by considering current Government bond rates of the right maturity, or b) do we want to estimate what can we expect to be the difference itself, i.e., the (risk) premium that can be expected to apply when you invest in the Market rather than in the risk free rate? Why?
