Introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently, and capitalized on the earlier work of Harry Markowitz on diversification and modern portfolio theory, capital asset pricing model (CAPM) is a pricing model used to determine the required rate of return on an asset, within a well-diversified portfolio (market portfolio), taking into account that asset’s systematic risk. Plainly put, this model describes the relationship between risk and expected return, whereby the expected return of a security or a portfolio equals the risk-free rate plus a relevant risk premium.

Investors, within the framework of CAPM, seek to obtain two types of compensations: one for the time value of money and the other for the risk involved. The first part, time value of money, is represented by the risk-free rate which compensates an investor for putting money in any investment over a period of time. The other part, risk premium, measures the amount of compensation an investor requires for assuming additional risk. Beta is a yardstick that compares an asset return to that of the market over a given period. By adjusting the market premium with the value of beta, a particular asset’s beta can be calculated.

The derived rate is then compared with the required return to tell whether an investment should be undertaken or not. When the resultant rate beats the rate an investor requires, investment is said to be feasible. Different combinations of risk (measured in betas) and corresponding return produce the so-called security market line (SML).

The following is an example: if the risk-free rate is 5%, the beta of the stock is 1.8 and the expected market return over the period is 8%, the stock return, as per CAPM, is:

r = risk-free rate + beta (market rate – risk-free rate)

r = 5%+1.8 (8% – 5%) = 10.4%