Last week, we talked about what a company’s beta is. I figured that this week, we would learn about the Capital Asset Pricing Model (CAPM). According to Investopedia, the CAPM is “a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.”
According to the third edition of Corporate Finance: Core Principles & Applications, the CAPM “implies that the expected return on a security is linearly to its beta.”
The equation: [pmath size=10]E(R) = R_f + beta * (E(R_m) – R_f)[/pmath]
[pmath size=10]E(R)[/pmath] is the Expect Return on a Security
[pmath size=10]R_f[/pmath] is the Risk-free rate
[pmath size=10]beta[/pmath] is the Beta of the security
[pmath size=10]E(R_m)[/pmath] is the Expected return on market
In the above graph, the Security Market Line is the depiction of the actual CAPM. Lets try an example. If the risk-free rate is 1%, the [pmath size=10]beta[/pmath] of the security is 1.2, and the expected market return on the market is 11%, then stock should return 13%.