Historical backgroundThe capital asset pricing model stands for an historic achievement to understand and quantify that risk is not at all simple .conceived and developed by economist William Sharpe 1964 Jack Treynor 1962 and John Lintner 1965 and Jan Mossin 1966This model was known revolutionised the theory and practice of investment by simplifying the portfolio selection problem as this model was developed by four economists but only one of them William Sharpe got noble prize in economics for this work in 1990 Jack Treynor wrote the draft for this model but never had published his work until recently .Another economist Markowitz ( 1952 ) presented a direct and obvious root to the CAPM Harry Markowitz provided the first authentic rigorous justification for selecting and diversifying a portfolio with publication of his paper “portfolio selection ” 2 IntroductionCAPM stands for capital asset pricing model . In finance this is a tool to calculate expected return based on the measurement of risk .The model relies on a risk multipliers known as “beta coefficient “DEFINITIONA model that describes the relationship between the risk and the expected return on an investment ,that is used to determine the appropriate price of investment 3 AssumptionCAPM is based on the following assumptions1:investors are wealth maximisers who select investment based on expected return and standard deviation2: investor can lend or borrow unlimited amounts at risk free rate 3: there are no restrictions on short sales4: all investor have the same expectations related to market5: there is no transaction cost6: tax free market7: no investor activities can influence market prices 8: quantities of all financial assets are given and fixedBefore going to discuss more about CAPM or formula of CAPM we need to understand the risk measurement factor the beta coefficientBeta coefficientAll the market securities has a beta coefficient of 1.0 and below 1.0 implies lower risk while above 1.0 implies a higher riskCAPM FORMULAThe formula of CAPM is also know as the security market line formula r* =KRF +b(KM-KRF)r*= required returnKRF = risk free rateKM =average market return b= beta coefficient 4 EXAMPLELet’s calculate the required return of two companies A and BThe risk free rate (KRF) and market return( KM ) of both companies is 0.10 % and 20.63 % respectively and beta coefficient of company A is 0.24 and company B is 0.34Company Ar* = KRF + b(KM-KRF )= 0.10% +0.24 ( 20.63% -0.10%) =5.02 %Company Br* = KRF + b(KM-KRF)= 0.10% +0.34 ( 20.63% -0.10%) = 7.08%USES OF CAPM1. Security comparison2. Portfolio and asset pricing3. To find the intrinsic value of securities4. To judge investment projects of all diverse kind of risk CAPM is used frequently 5 Advantages and disadvantages of CAPM Advantages :-1- Ease of use2- CAPM is a simple model to calculate the expected return3-CAPM takes into account systematic risk / market risk is an important variable Because it is unforeseen4- it generates a theoretically derived relationship between expected return andsystematic riskDisadvantages :-1- risk free rate the commonly accepted rate used as Rf the yield on short term securities2-based on the assumed values3- the required return provide lower return in reality than what the model calculatesCONCLUSIONThe empirical test of the CAPM given as in above example showed that CAPM was fairly successful in predicting the price of individual assets