CAPM is an economic model that describe how securities are priced in the market place.This model describe the relationship between systematic risk and expected return.
Assumption of CAPM
1) The investor objective is to maximize the ability of terminal wealth.
2) Investor make choices on the basis of risk and return.
3) Investor have homogeneous expectation of risk and return.
4) Investor have identical time horizon.
5) Information is freely and simultaneously to investor.
6) There is a risk free assets and investor can borrow and lend unlimited amount at the risk free rate.
7) There are no taxes,transaction costs restriction on short rates and other market imperfction.
8) Total assets quantity is fixed and all assets are marketable and divisible.
ERi=Expected return on investment
Rf=Risk free rate
βi=Beta of investment
ERm=Expected reutn of market
(ERm-Rf)=Market risk premium
CAPM goal to evaluate whether a stock is fairly valued when CAPM time value of money are compare to its expected return.CAPM also assume risk free rate will remain constant over the discounting period.