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Capital Asset Pricing Model is merely a theoretical construct developed by William Sharpe and John Lintner wherein a security’s return is directly related to its systematic risk that is, the component of risk which cannot be neutralized through diversification.(example major political, economic and social phenomena)

The CAPM model is expressed as follows:

Expected rate of return

= Risk-free rate of return + Risk premium

Further the model suggests that prices of assets are determined in such a way that the risk premiums or excess returns are proportional to systematic risk, which is indicated by the BETA coefficient( shows the sensitivity of return on a security or a portfolio to return from the market).

Accordingly, the relationship

Risk premium

=[Return on market portfolio - Risk free return] (Beta Security)

determines the risk premium. Thus according to the model, the expected rate of return is related to the Beta coefficient. This relation is portrayed by the security market line ( a linear relationship between the expected rate of return on a security and its systematic risk indicated by beta)

The purpose of the CAPM is often used to compute the cost of equity for a firm. By filling in the riskless rate of interest, the expected return on the market and the firm’s beta into the formula, the cost of equity can be estimated.

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