What does the CAPM formula relate?

The Capital Asset Pricing Model (CAPM) formula is fundamental in finance as it establishes a relationship between the expected return of an asset and its systematic risk, which is quantified by the asset's beta. CAPM essentially articulates that an investor should be compensated for both the time value of money, represented by the risk-free rate, and the risk associated with holding a risky asset, which is reflected in the market risk premium times the asset's beta.

In simpler terms, the model suggests that higher risk corresponds to higher expected returns. This allows investors to assess whether an investment's expected return is sufficient compensation for its risk. By using the CAPM, investors can make informed decisions regarding the trade-off between risk and return in their portfolios, which is crucial for effective asset pricing and portfolio management. This principle underpins many investment strategies and corporate finance decisions, influencing how capital is allocated in the market.