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Capital Asset Pricing Model (CAPM)

💼 Business By CampusDown Wiki Editorial Team Last updated
Quick answer: CAPM says an asset's expected return equals the risk-free rate plus beta times the market risk premium, so only systematic risk that diversification cannot remove is rewarded.
Contents
  1. 1. Formula
  2. 2. Beta and systematic risk
  3. 3. CML and SML
  4. 4. Assumptions and critiques
  5. 5. References

Formula

E(Ri) = Rf + βi[E(Rm) − Rf]. With a 3% risk-free rate, 8% expected market return and beta 1.2, the required return is 9%, used as the cost of equity in valuation.

Beta and systematic risk

Following Markowitz, diversification removes firm-specific risk, leaving market-wide risk. Beta = Cov(Ri,Rm)/Var(Rm); above 1 means more sensitive than the market.

CML and SML

The capital market line relates efficient portfolios' returns to total risk; the security market line relates any asset's return to beta. Assets above the SML look undervalued.

Assumptions and critiques

It assumes mean-variance investors, homogeneous expectations, risk-free borrowing and no frictions. Roll argued the true market portfolio is unobservable; Fama and French (1992) found size and book-to-market explain returns better, leading to the three-factor model. Ross's APT allows multiple factors. CAPM remains widely used for its simplicity; anomalies are also studied in behavioural finance.

References

  1. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425-442.
  2. Lintner, J. (1965). The valuation of risk assets and the selection of risky investments. Review of Economics and Statistics, 47(1), 13-37.
  3. Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46.
  4. Roll, R. (1977). A critique of the asset pricing theory's tests. Journal of Financial Economics, 4(2), 129-176.

Reports and materials that use this theory (Korean)

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This article was last updated on October 15, 2026. It is based on widely recognized original works and textbooks; when citing it in a paper, please check the original sources listed in the references.