Capital asset pricing model

The capital asset pricing model (CAPM) is a tool for figuring out risk of stock profit or losses (called returns).

It makes an assumption, which is that investors care only about two things: the average returns of stocks over, for example, ten years, and the volatility of annual returns around that average during the same period.

The main result of the model is that the return of a stock can be broken down in the sum of two things: a risk-free rate and a risk premium. This risk premium can be seen as the product of two things: a measure of the risk of the stock (called the "beta") and the average reward for risk in the market (the "equity risk premium", which is the return of the market over and above the risk-free rate).

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