The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and the expected return of assets, particularly stocks. It is widely used in the finance industry.
CAPM calculates the expected return of a stock with the formula: risk-free rate + the beta of the stock x (the expected return of the market – the risk-free rate). The risk-free rate is usually a GILT bond yield.
For example, if the risk-free rate is 1%, the beta of the stock is 1.3 and the market return is 10%, then the expected return of that stock would be: 1% + 1.3 x (10% – 1%) = 12.7%.
The risk-free rate in the CAPM formula represents the time value of money, with the other components representing additional risk taken. The higher the beta of the stock, the higher the expected return.
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