The Capital Asset Pricing Model, often known as CAPM, is a model describing the link between a security’s expected return and systematic risk. It indicates that a security’s expected return is equivalent to the risk-free return and a risk premium based on the security’s beta. The CAPM model is frequently used in finance to produce expected returns for assets based on their risk and cost of capital and price risky securities.
Risk and the time value of money are supposed to be paid for by investors. The risk-free rate in the CAPM formula takes the time value of money into the account. The CAPM formula’s remaining components account for the investor’s desire to accept higher risk.
A prospective investment’s beta measures how much risk it will bring to a portfolio that resembles the market. A higher beta implies that a stock is riskier than the market. The equation argues that a stock with a beta of less than one will mitigate a portfolio’s risk.
The market risk premium, which would be the expected return from the market just above the risk-free rate, would then be multiplied by the stock’s beta. The risk-free rate would then be increased by the stock’s beta and market risk premium’s product. The outcome should provide an investor with the required return or discount rate to determine the asset’s value.