Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security.

The formula takes into account the asset's sensitivity to non-diversifiable risk (aka. systematic risk or market risk), in a number often referred to as beta in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

The relationship is:

E(R_i) = R_f + beta_i x [E(R_m) - R_f]

Where:

E(R_i) = The expected return on the capital asset,

beta_i = The sensitivity of the asset returns to market returns,

E(R_m) = The expected return of the market, and

R_f = The risk-free rate of interest.

Once the expected return, E(R_i), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset.

• CAPM article on RiskGlossary.com