# Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a model that investors use to determine the rate of return of an investment. The model describes the relationship between the expected return of an investment and its risks. Furthermore, CAPM is one of the most commonly used models in finance for pricing risky stocks. Both investors and businesses use the model to calculate their rate of return.

For investors, CAPM can help with the calculation of the required rate of return. More importantly, it can help them develop a diversified portfolio of investments. For companies and businesses, CAPM helps with the calculation of the cost of equity. They can use the cost of equity in different processes such as investment appraisal or in the calculation of Weighted Average Cost of Capital (WACC).

### Capital Asset Pricing Formula

To calculate the rate of return using CAPM investors and businesses use the following formula.

E(r)i = Rf + βi (E(r)m – Rf)

In the above formula, ‘E(r)i’ represents the expected rate of return of an investment or stock. ‘Rf‘ signifies the risk-free rate of return prevalent in the market. ‘βi’ represents the beta of the investment. Finally, ‘E(r)m‘ denotes the average rate of return in the market. Together, (E(r)m – Rf) represents the market risk premium.

#### Risk-free rate of return

The risk-free rate of return is the rate of return of a risk-free investment. Usually, it represents a theoretical rate of return and is close to the rate of return of short-term government treasury bills. For most calculations, investors can use the rate of return on those treasury bills instead of calculating the risk-free rate of return.

#### Beta

The most important part of the CAPM model is the Beta factor or coefficient of an investment. Beta represents the systematic risk of an investment. Systematic risk is the risk that applies to the market as a whole and not to a specific company or stock. Usually, companies with a beta of above 1 are riskier than the market. A beta of lower than 1 represents a lower risk than the market.

The market risk premium of an investment represents the premium above the risk-free rate of return in the market. It is calculated by deducting the risk-free rate of return from the average market rate of return. In simpler words, the market risk premium is the difference between the average market rate of return and the risk-free rate of return.