The Capital Asset Pricing Model (CAPM) is a theoretical model used in finance to determine the expected return on an investment, given its risk relative to the market as a whole. It sets the relationship between the expected return and risk, and it’s used to price risky securities and to generate an expected return which should account for the riskiness of these securities.
The model takes into account the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM is a widely-used finance theory that establishes a linear relationship between the required return on an investment and risk.
The formula of the model is:
Expected Return = Risk-Free Rate + β (Market Return – Risk-Free Rate)
