In finance, the capital asset pricing model (CAPM) is used to find out a theoretically correct required rate of return on an asset, if that asset is to be added to an previously well-diversified portfolio, and also given that asset's non-diversifiable risk. This model takes into account the asset's sensitivity to non-diversifiable risk which is also known as systematic risk or market risk. Generally it is represented by the quantity beta (β) in the financial sector, as well as the expected return of the market and expected return of a theoretical risk-free asset.
The model was introduced by John Lintner (1965), William Sharpe (1964), Jack Treynor (1961, 1962), and Jan Mossin (1966) independently building on the past work of Harry Markowitz on diversification and modern portfolio theory. They got Noble Memorial Prize for their work.
The CAPM is a model designed for determination of pricing an individual security or portfolio. For individual securities, one can make use of the security market line (SML) and calculation of its relation to expected return and systematic risk (beta) to demonstrate how the market must price individual securities in connection to their security risk class. To calculate the reward-to-risk ratio for any security in relation to that of the overall market SML is the best tool. Consequently, when the expected rate of return for any security is discouraged by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equivalent to the market reward-to-risk ratio, so:
The market reward-to-risk ratio is effectively the market risk premium and by reorganizing the above equation and calculating for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
(beta) is the sensitivity of the expected excess asset returns to the expected excess market returns,,
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