Capital Asset Pricing Model

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

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$$r_a = r_f + \beta (r_m - r_f)$$

Where

• $r_f$ the risk-free rate
• $r_m$ the expected market return
• $\beta$ the risk measure/security

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 rate $r_f$ 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 the returns of the asset to the market over a period of time and to the market premium $(r_m-r_f)$.