Originally developed by Harry Markowitz in 1952, capital asset pricing model shows the relationship between expected return and expected risk. It is based on the assumption that investors look for additional expected return (called the risk premium) if asked to accept additional risk.
According to this model, the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a risk premium multiplied by the asset's systematic risk.
The formula of CAPM is given by:
r= Rf + Beta*(Rm-Rf)
r= expected rate of return on the security.
Rf= rate of a risk free investment
Rm= expected excess return of the market
CAPM is useful for estimating the correct equilibrium market price of company’s shares as well as the cost of a company’s equity, taking account of the risk characteristics of a company’s investments, both business and financial risk.
a. Investors have homogenous expectation about asset returns.
b. Markets are frictionless—the borrowing rate is equal to the lending rate.
c. There are no market imperfections such as taxes etc.