What Is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a financial framework that establishes the relationship between systematic risk (market-wide risks) and the expected return on assets, particularly stocks. It provides a linear equation to determine the required return on an investment based on its risk profile.
CAPM relies on three key components:
- Beta (β): Measures an asset’s volatility relative to the market.
- Risk-Free Rate (Rf): Typically the yield on Treasury bills.
- Equity Risk Premium (ERm − Rf): The excess return expected from the market over the risk-free rate.
Widely used in finance, CAPM helps price risky securities, evaluate investment opportunities, and assess cost of capital.
Key Takeaways
- CAPM calculates expected returns using market risk premium, beta, and the risk-free rate.
- It assumes a linear relationship between risk and return.
- Limitations include unrealistic assumptions (e.g., efficient markets) and reliance on historical beta.
- Despite flaws, CAPM remains popular for its simplicity and comparative analysis.
- Often paired with Modern Portfolio Theory (MPT) to optimize portfolios.
CAPM Formula
The expected return of an asset is computed as:
ERi = Rf + βi × (ERm − Rf)
Where:
- ERi: Expected return of the investment.
- Rf: Risk-free rate.
- βi: Beta of the investment.
- (ERm − Rf): Market risk premium.
👉 Explore how beta impacts your portfolio
How Beta Works in CAPM
- Beta > 1: Stock is riskier than the market.
- Beta < 1: Stock is less volatile than the market.
- Beta = 1: Mirrors market risk.
Beta is multiplied by the market risk premium to adjust for an asset’s specific risk.
Practical Example
Scenario:
- Stock price: $100/share.
- Annual dividend: 3%.
- Beta: 1.3.
- Risk-free rate: 3%.
- Expected market return: 8%.
Calculation:
ERi = 3% + 1.3 × (8% − 3%) = 9.5%
If discounted future cash flows align with $100, the stock is fairly valued.
Limitations of CAPM
Unrealistic Assumptions:
- Markets are perfectly efficient (often untrue).
- Investors are rational and risk-averse.
Beta’s Shortcomings:
- Historical beta may not predict future risk.
- Ignores asymmetric volatility (e.g., downside shocks).
Static Risk-Free Rate:
- Assumes constant Rf, which fluctuates in reality.
Alternative Models:
- Fama-French 3-Factor Model: Adds size and value factors.
- Arbitrage Pricing Theory (APT): Multifactor approach.
CAPM vs. Efficient Frontier
While CAPM evaluates individual assets, the efficient frontier optimizes entire portfolios:
- Capital Market Line (CML): Best risk-return tradeoff for portfolios.
- Security Market Line (SML): Links beta to expected returns for stocks.
👉 Learn more about optimizing risk-return
FAQs
1. Who developed CAPM?
Answer: William Sharpe, Jack Treynor, and others in the 1960s, building on Harry Markowitz’s MPT.
2. What are CAPM’s core assumptions?
Answer: Efficient markets, rational investors, no taxes/transaction costs, and linear risk-return.
3. How is beta calculated?
Answer: Via statistical regression of an asset’s returns against market returns.
4. Can CAPM be used internationally?
Answer: Yes, via the International CAPM (ICAPM), which accounts for currency risks.
5. Why is CAPM still used despite flaws?
Answer: Simplicity, benchmark utility, and ease of comparing investments.
Bottom Line
CAPM offers a foundational approach to linking risk and return, though its assumptions often diverge from real-world conditions. Investors use it alongside tools like MPT and multifactor models to refine decisions. Always validate CAPM outputs with market context and alternative analyses.
For deeper dives, consult financial textbooks or certified advisors.
🚀 Pro Tip: Combine CAPM with qualitative analysis for robust valuations.