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Capital Asset Pricing Model or CAPM is an investment model widely used by investors to determine return and risk associated with an investment or portfolio. CAPM is also used to determine whether a security is over-valued or under-valued. The general idea is if the investor takes any risk there must be sufficient return from it, called risk premium. The formula of CAPM is

R = Rf + beta x (Rm - Rf)

Where R is the expected return (also known as Cost of Capital), Rf is the rate of risk-free investments (or time value of money), beta is the beta value (risk associated) of the security or index, and Rm is the expected return from market. Investors following Capital asset pricing model invest in securities, if the expected return (R) equals or exceeds required return. Fore example if the risk-free ratio is 4%, the beta value of security is 3% and expected return from market is 10%, then expected return will be 4+3(10-4) = 22%.

The greatest advantage of Capital asset pricing model is the idea that risk-return relation of every portfolio can be optimized to attain lowest risk for a specific level of return. Many investors following CAPM prefer to invest in low-cost index funds rather than on stocks. CAPM necessitates diversification of portfolio.

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