Capital Asset Pricing Model (CAPM)

A financial model expressing the relationship between expected risk and expected return. Investors demand higher returns for higher risks. Taking that into account, the model states that the return on an asset or a security is equal to the rate on a risk-free security, plus a risk premium multiplied by the asset's systematic risk. The model also asserts that the only risk that is priced by rational investors is systemic risk, because it cannot be eliminated by diversification.

The CAPM makes the following assumptions:

  • There are no taxes or transaction costs;
  • all investors have identical investment horizons; and
  • all investors have identical opinions about expected returns, volatilities, and correlations of available investments.