The Capital Asset Pricing Model (CAPM) is a widely-used financial model that helps investors determine the expected return on an asset based on its level of risk. The basic equation for the CAPM is as follows:
r_i = r_f + β_i (r_m – r_f)
- r_i is the expected return on asset i
- r_f is the risk-free rate of return
- β_i is the asset’s beta, which measures its volatility in relation to the market as a whole
- r_m is the expected return on the market as a whole
The equation states that the expected return on an asset is equal to the risk-free rate plus a premium based on the asset’s beta and the expected return of the market. The premium is calculated as the difference between the expected return on the market and the risk-free rate, multiplied by the asset’s beta.
The CAPM is based on several assumptions, including that investors are rational and risk-averse, and that markets are efficient and information is freely available. It is often used to calculate the cost of equity for a company, which is the return that investors expect to receive for holding the company’s stock.
While the CAPM has its limitations and critics, it remains a widely-used model for estimating the expected return on an asset, and is an important tool for investment professionals.