What is Capital Asset Pricing Model

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The capital asset pricing model is vital for investment valuation

The capital asset pricing model:

• Is an effective method for calculating the required return on investment based on an assessment of their market risk;
• Is applied within the framework of a specific financial system;
• Is based on the principle of equilibrium between the expected return of an investor's asset portfolio and investment risk;
• Takes into account a company's systematic risk level in regard to the stock market as a whole.

Explanation of the capital asset pricing model

This model defines the level of return on assets that investors expect to receive by correlating risk and expected return.

According to this model, the expected return that investors will require is determined by the sum of the risk-free rate and risk premium.

The model considers risks: systematic - which the market portfolio has, and specific - specific to each type of asset.

The risk-free return rate is the minimum return level that investors can demand from investments in the absence of risk. This is possible when the actual and expected return on investment are precisely the same.