Core of modern finance: Capital Asset Pricing Model

Updated: Aug 23, 2020


In modern finance, capital asset pricing model (CAPM) is one of the key theories every finance fundamental textbook would discuss.


Where,

E(ri) = return required on financial asset i

Rf = risk-free rate of return

βi = beta value for financial asset i

E(rm) = average return on the capital market

Q: Which area of capital asset pricing model (CAPM) relevant?

A: CAPM is relevant under business finance. It is the model to find the cost of equity by considering systematic risk (beta) of particular financial asset.


Q: What does CAPM assume?

A: The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk.

Q: What is CAPM?

A: CAPM formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium - βi (E(rm) – Rf) – which compensates the investor for the systematic risk of the financial asset. If shares are being considered, E(rm) is the required return of equity investors, usually referred to as the ‘cost of equity’.

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