Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk, specifically systematic risk measured by beta ($\beta$). The formula $E(R_i) = R_f + \beta_i [E(R_m) - R_f]$ calculates the expected return on asset by adding the risk-free rate () to the product of the asset's beta () and the market risk premium (). Beta indicates the sensitivity of the asset to market movements, with values above 1 signaling higher volatility and below 1 indicating lower volatility relative to the market. CAPM assumes efficient markets, rational and risk-averse investors, and that only systematic risk affects expected returns. This model is fundamental in accountancy for estimating the cost of equity, which is essential for capital budgeting, investment appraisal, corporate finance, and calculating the Weighted Average Cost of Capital (WACC). It also supports portfolio management and helps ensure regulatory compliance in financial reporting by linking expected returns to risk levels.