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Capital Asset Pricing Model - CAPM

What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The other half of
the formula represents risk and calculates the amount of compensation the investor needs for taking
on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).
Investopedia explains Capital Asset Pricing Model - CAPM
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security
plus a risk premium. If this expected return does not meet or beat the required return, then the investment
should not be undertaken. The security market line plots the results of the CAPM for all different risks
(betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in
this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected
market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).