Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a finance model that links an asset’s expected return to its exposure to systematic market risk.

The central idea is that investors should be compensated for time value of money and for bearing market-related risk that cannot be diversified away.

Core Formula

In its standard form:

Where:

• (R_f) is the risk-free rate
• (\beta) measures sensitivity to market movements
• (E(R_m) - R_f) is the market risk premium

Why It Matters

CAPM is often used to estimate a cost of equity, benchmark expected return, or compare whether an asset’s return looks adequate given its systematic risk.

It is especially useful when analysts need a disciplined way to connect required return with beta.

Worked Example

Suppose the risk-free rate is 3%, the market risk premium is 5%, and a stock’s beta is 1.2.

Under CAPM, the expected return would be:

That 9% becomes a candidate required return for valuation work.

Scenario Question

An investor says, “A higher-beta stock should always outperform in every short period.”

Answer: No. CAPM is an expected-return framework, not a guarantee about short-run realized performance.

Related Terms

• Beta: Beta is the risk measure at the center of CAPM.
• Risk-Free Rate: The baseline return in the model.
• Market Risk Premium (MRP): The compensation investors require for taking market risk.
• Equity Risk Premium: Closely related to the return premium used in equity valuation.
• Weighted Average Cost of Capital (WACC): CAPM is often used to estimate the cost of equity input inside WACC.

FAQs