The capital asset pricing model (CAPM) provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate.
Risk in the Capital Asset Pricing Model Formula
To understand the capital asset pricing model, there must be an understanding of the risk of an investment. Individual securities carry a risk of depreciation which is a loss of investment to the investor. Some securities have more risk than others and with additional risk, an investor expects to realize a higher return on their investment. For example, assume that an individual has $100 and two acquaintances would like to borrow the $100 and both are offering a 5% return($105) after 1 year. The obvious choice would be to lend to the individual who is more likely to pay, i.e., carries less risk of default. The same concept can be applied to the risk involved with securities.
The risk involved when evaluating a particular stock is accounted for in the capital asset pricing model formula with a beta. Specifically regarding the capital asset pricing model formula, beta is the measure of risk involved with investing in a particular stock relative to the risk of the market. The beta of the market would be 1. An individual security with a beta of 1.5 would be as proportionally riskier than the market and inversely, a beta of 0.5 would have less risk than the market.
Risk-Free Rate in the Capital Asset Pricing Model Formula
The risk-free rate would be the rate that is expected on an investment that is assumed to have no risk involved. For the US, the US treasury bill rate is generally used as it is short-term and the collapse of the treasury bill would theoretically, at a minimum, be a large enough disruption to inhibit gauging value, or at worse, be a collapse of the entire monetary system which relies on a fiat currency.
