Capital asset pricing model

Description

In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk. The model takes into account the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. Capital asset pricing model “suggests that an investor’s cost of equity capital is determined by beta.

Related formulas

Variables

ERiThe expected return on the capital asset (dimensionless)
RfRisk free rate of interest (dimensionless)
βiThe sensitivity of the expected excess asset returns to the expected excess market returns (dimensionless)
ERmThe expected return of the market (dimensionless)