Capital asset pricing model ( including size premium and specific risk)

Description

In finance, the capital asset pricing model (CAPM) 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. CAPM “suggests that an investor’s cost of equity capital is determined by beta.” CAPM can be modified to include size premium and specific risk.

Related formulas

Variables

ERiRequired return on security i (dimensionless)
RfRisk-free rate (dimensionless)
βThe sensitivity of the expected excess asset returns to the expected excess market returns (dimensionless)
RPmGeneral market risk premium (dimensionless)
RPsRisk premium for small size (dimensionless)
RPuRisk premium due to company-specific risk factor (dimensionless)