What does the capital asset pricing model illustrate?

The capital asset pricing model (CAPM) is a foundational concept in finance that illustrates the linear relationship between the expected return of an asset and its systematic risk, which is measured by beta. In essence, CAPM suggests that investors must be compensated for both the time value of money and the risk associated with holding a risky asset.

Under this model, the expected return of an asset is calculated as a function of the risk-free rate of return plus a risk premium that is proportional to the asset's beta. This linear relationship is depicted in the CAPM equation:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

This equation highlights that as the risk, represented by beta, increases, the expected return also increases proportionately, resulting in a straight line when plotted on a graph. This clarity and predictability in the relationship between risk and return make CAPM an essential tool for investment analysis and portfolio management.