Capital Asset Pricing Model

The Capital Asset Pricing Model defines the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and cost of capital. The CAPM uses the principles of Modern Portfolio Theory to determine if a security is fairly valued. It relies on assumptions about investor behaviors, risk and return distributions, and market fundamentals that don’t match reality.

ERi = Expected return of investment

Rf = Risk-free rate

βi = Beta of the investment

ERm = Expected return of market

(ERm - Rf) = Market risk premium