The Capital Asset Pricing Model CAPM

The Capital Asset Pricing Model is the model for the pricing of risky securities. The CAPM would better explain the relationship between the expected return and the risk related to the investment. A formula is used to better explain the CAPM relationship.

Required Return = RF Rate + (MR - RF Rate)*Beta

The RF Rate is the risk free rate for the investment. MR stands for the expected market return, while the Beta is a value that determines the performance of a stock.

If you intend to buy stocks from a certain company and would like to know how the company's stocks would perform the following year, you may use this CAPM formula. Let's say the risk free rate in the market is at 5%, and the market is expected to perform by 12% the following year. You then need to look for the Beta of the stock that you are interested in purchasing. If the Beta of the company is at 1.9, while the entire stock market has an overall beta of 1.0, this would tell you that investing in the company carries more risk, therefore, you should expect a higher rate of return than the market's current 12%.

Replacing the variables in the formula, this would give you a required return of 18.3% for that specific company. This would translate to expecting the company to make a rate of return of 18.3%. If you don't think the company's stock cannot do this, you should look into investing in another stock.