In layman's terms, the CAPM formula is: Expected return of the investment = the risk-free rate + the beta (or risk) of the investment * the expected return on the market – the risk free rate (the difference between the two is the market risk premium).
What does the CAPM model tell us?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security.
What are the components of CAPM equation?
CAPM Formula Per the capital asset pricing model (CAPM), the cost of equity – i.e. the expected return by common shareholders – is equal to the risk-free rate plus the product of beta and the equity risk premium (ERP). Where: Ke → Expected Return on Investment. rf → Risk-Free Rate.
How do you explain beta in CAPM?
Beta (β), primarily used in the capital asset pricing model (CAPM), is a measure of the volatility–or systematic risk–of a security or portfolio compared to the market as a whole.
How do you calculate cost of equity in CAPM?
Using the capital asset pricing model (CAPM) to determine its cost of equity financing, you would apply Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return) to reach 1 + 1.1 × (10-1) = 10.9%.