The Capital Asset Pricing Model (“CAPM”) is, as its name suggests, a simplified model of how asset pricing works. In short, the expected excess return of the security (excess return is returns above that of a risk-free asset such as 10-year treasury note) in question should be directly proportional to its variance or riskiness. Consider the following example: suppose the risk-free rate of return was 1% annually. Suppose a business is issuing a bond, and every investor believes there is a 100% chance that the business will repay, then bond buyers will keep bidding the price until it equals exactly 1% since any price in excess of 1% would just mean that anyone who currently holds a risk-free asset would prefer the new bond over their existing one (assuming no transaction costs). Now assume that the probability of repayment is 50% instead of 100%, and in the case where the business doesn’t repay it pays back nothing. While a 2% rate of return on such a bond would result in the same expected return (50% times 2% = 1%), no investor would ever buy such an asset: why flip a coin for 2% or 0% instead of taking the guaranteed 1%? Instead, the expected return needs to be greater than 1% in order for investors to be willing to take that risk.
In the real world, CAPM fails to accurately predict asset prices. Instead, it is best understood as a toy model used as an introduction to the world of asset pricing.