Formula for calculating the expected rate of return according to capital asset pricing model is as follows:
Expected return of the investment = the risk free rate + the beta or we can say it as the risk of the investment * the expected rate of return on the market – the risk free rate , the difference between the two i.e expected rate of return and the risk free rate is known as the market risk premium.
For every additional increment of risk incurred, the expected return should increase propotionately.
If any security is found to give a higher return in relation to the additional risk incurred, then the CAPM model shows that it is a buying opportunity.
Despite shortcomings of the CAPM model , this model is very popular for valuing securities.
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