CAPM – what is it?

CAPM is a mathematical model that estimates the expected returns of an investment based on its riskiness relative to the rest of the market.

It compares the relationship between systematic risk and the expected returns of an asset usually equities.

CAPM establishes the required return on an investment and its risk and whether it is worthy of our investment by telling us if it is expensive or cheap. Of course it has its downfalls but it is a good gauge for the most part.

This financial model is based on the relationship between an asset’s beta (its performance/risk vs the benchmark), the risk-free rate (usually T-bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate. I also call this the spread between yields.

Beta > 1. Riskier than market

Beta < 1. Less risky than market

CAPM formula

Expected Return of Asset = Risk Free Rate + Beta(ERP)