What is the CAPM model?
Investors want a rate of return that compensates them for taking on risk. The capital asset pricing model (CAPM) helps to calculate investment risk and what return should be expected. The model begins with the idea that individual investment has both systematic risk and unsystematic risk. Systematic risks are those that cannot be diversified away such as interest rates and wars. Unsystematic risks are specific to individual stocks and can be diversified away by increasing the number of stocks in an investor’s portfolio. The capital asset pricing model evolved as a way to measure systematic risk. CAPM describes the relationship between risk and expected return. The formula is:
In the formula 
= required return on security, 
= risk-free rate of return, 
= beta of the security and 
= Equity market premium.
According to CAPM the only relevant measure of a stock’s risk is beta. It measures a stock’s relative volatility. In other words it shows how much the price of a particular stock goes up and down in relation to the movement of the market as a whole. A share price that moves exactly in line with the market has a beta of 1.
A stock with a beta of 1.2 would rise by 12% if the market rose by 10%, and fall by 12% if the market fell by 10%. CAPM tells us it is only possible to earn higher returns than those of the market as a whole by assuming a higher risk (beta).
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