The Capital Asset Pricing Model (CAPM) is a model that indicates the relationship between return and risk of the asset and also provides a framework to determine the required rate of return on an asset. The required rate of return stated by CAPM assist in valuing an asset. With the help of CAPM one can also compare the expected (estimated) rate of return on an asset with its required rate of return and determine whether the asset is fairly valued.
The primary idea behind CAPM is that a buyer of a risky asset should be compensated by the risk he/she is taking. This compensation is done through two ways –
The Risk and Time value of money. The time value of money is defined by the risk-free return that the investor could get if the same amount of money is invested in a risk-free security, like government bonds, over the same period of time for which he/she is investing in a risky asset.
Here, risk is measured by an element called beta which is the extra amount of money that the investor could get for taking on additional risks.