Capital Asset Pricing Model

William Sharpe published the capital asset pricing model (CAPM). Parallel work was also performed by Treynor and Lintner. CAPM extended Harry Markowitz’s portfolio theory to introduce the notions of systematic and specific risk

CAPM considers a simplified world where:
1. There are no taxes or transaction costs.
2. All investors have identical investment horizons.
3. All invetors have identical opinion about expected returns, volatilities and correlations of available investments

CAPM decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk of holding the market portfolio. As the market moves, each individual asset is more or less affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is unique to an individual asset. It represents the component of an asset's return which is uncorrelated with general market moves.
According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk, but through diversification, the investor's net exposure is just the systematic risk of the market portfolio.
Systematic risk can be measured using beta. According to CAPM, the expected return of a stock equals the risk-free rate plus the portfolio's beta multiplied by the expected excess return of the market portfolio.
r = Rf + beta x ( Km - Rf )

where,
r is the expected return rate on a security;
Rf is the rate of a "risk-free" investment, i.e. cash;
Km is the return rate of the appropriate asset class.
Beta measures the volatility of the security, relative to the asset class. The equation is saying that investors require higher levels of expected returns to compensate them for higher expected risk. You can think of the formula as predicting a security's behavior as a function of beta: CAPM says that if you know a security's beta then you know the value of r that investors expect it to have.