# Capital asset pricing model (CAPM)

The capital asset pricing model is an equation to show the relation between investment return and the risk of the investment for a given tenure (or a single period, without any incremental investments).

**How to calculate returns under CAPM Model?**

**E(r)= Rf+ (Rm-Rf)*B**

E(r) is the expected returns on the asset, expressed as a percentage, for a given tenure

Rf is the minimum risk-free interest rate/returns of absolutely risk-free security for the same tenure as the investment under question, in a no-inflation scenario. Truly risk-free security is a government-issued bond, carrying a sovereign guarantee, with a fixed rate of interest.

Rm is the broader market returns

B is the **beta** or risk factor of the asset

**How does CAPM Model work?**

CAPM is used to estimate returns from securities which are riskier than, say, sovereign bonds of absolute risk-free nature. Hence, in effect, the returns, too, would be higher than on the risk-free option. (Rm-Rf)*B shows by how much our chosen security will give returns above the prevalent risk-free instrumentâ€™s returns, being part of the larger volatile market. Beta is factored in as it is the systematic risk of the security, as part of the larger **volatile**** **market (subject to market forces).

**What are CAPM assumptions?**

- Market is perfect
- Investors are risk-averse
- There is no transaction cost
- Investors have homogeneous expectations
- Price-takers
- Lending & borrowing can be done risk-free rate of interest
- No inflation exists in the market
- Beta is the only measure of risk

The CAPM model is criticized for its assumptions. It is more of a theoretical representation of financial markets.