Question

Explain the capital asset pricing theory.

Answer 1

Financially capital asset pricing theory used to confirm theoretically perfect rate of return of an asset to make decisions regarding adding assets to well-diversified portfolio.

Capital Asset Pricing theory explains relationship between systematic risk and expected return for assets i.e. stocks.  

Its widely used throughout finance for pricing securities and generating expected returns for assets given risk of those assets and capital pricing.

Investors expects compensation for risk and value of money.  

                  ERi = Rf + Bi (ERm - Rf)

ERi = Expected return of investment,

Rf = Risk-free rate,

βi = Beta of the investment,

ERm = Expected return of market,

(ERm - Rf) = Market risk premium.