CAPM

CAPM stands for Capital Asset Pricing Model. This model tries to relate between return of securities and the risk of the securities. CAPM is developed by Treynor, Sharpe, and Lintner. This model can be used to calculate the value of the securities such as stocks. The idea of this model is that rational investors will demand additional return if they take the additional risk (called risk premium). CAPM decomposes portfolio risk in two categories systematic risk and unsystematic risk (firm risk/unique risk). According this model investor will get compensation from the market because of taking systematic risk from that portfolio. The model of CAPM is

     R_e = R_f + β_e (R_m – R_f)

• R_e = expected return for security
• R_f  = risk-free rate
• R_m = market return
• β_e  = Beta of security (measure systematic risk)

 To get Beta (β_e)  we can use simple regression model. 

     R_e = R_f + β_e (R_m – R_f) + α

     R_e –  R_f  = α  + β_e (R_m – R_f)  

Substitute R_e –  R_f   with Y and R_m – R_f  with X, then we can get simple regression model 

      (R_e –  R_f)  = α  + β_e (R_m – R_f)      

          Y        = α  +      β X