Investment formula: The capital asset pricing model

Capital asset investment has been theorized to follow a model known as the capital asset pricing model (CAPM). It basically correlates the relationship between the risks and expected returns of capital assets and is mainly used in its pricing structure. The idea behind CAPM is that investors must be compensated for the time value of money and risks.

The time value of money relates to the compensations investors receive by placing money in any investment over a period while the latter is represented by the compensation received by the investor by taking on additional risks. The model further states that the expected return of a capital asset must equal the rate of the risk-free security plus a risk premium. If the risk-free security and the risk premium are higher, then the expected return must be higher as well and vice versa. If, however, the returns and the risks do not balance out, then the business venture should not be continued.

Other assumptions that are under the CAPM are that investors hold a diverse set of portfolios (a systematic return for the risk of their portfolios is the only requirement since unsystematic risk has been removed), that there is a single-period transaction horizon (the holding period commonly used is one year), that they can borrow and lend money at a risk-free rate of return, and that a perfect capital market exists (all securities hold a correct value and that their returns will be plotted on the security market line).

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