CAPM

Capital Asset Pricing Model — a foundational framework that estimates an asset's expected return as the risk-free rate plus its beta times the market risk premium.

The Capital Asset Pricing Model, developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s, expresses a security's expected return with a single equation: Expected Return = Risk-Free Rate + β × (Market Return − Risk-Free Rate). The term in parentheses is the equity risk premium — the extra return investors demand for holding stocks instead of risk-free Treasury bills. Beta scales that premium up or down according to how much systematic risk the asset carries. A stock with a beta of 1.5 is expected to earn 1.5 times the market premium above the risk-free rate.

The central insight of CAPM is that investors are compensated only for systematic (market-wide) risk, not for company-specific risk. Idiosyncratic risk — a product recall, a failed drug trial, a CEO scandal — can be diversified away by holding many stocks, so the market does not reward bearing it. Only beta, the portion of risk that moves with the overall market and cannot be diversified away, commands a return premium. This conclusion underpins modern portfolio theory and the entire case for broad diversification.

CAPM is foundational but empirically imperfect. Real-world returns deviate from its predictions: low-beta stocks have historically delivered higher risk-adjusted returns than the model implies (the "low-volatility anomaly"), and factors beyond beta — size, value, momentum, profitability — explain returns that CAPM cannot. The Fama-French models extend CAPM by adding these factors. Despite its limitations, CAPM remains the standard starting point for estimating the cost of equity in corporate finance, valuation, and the calculation of alpha.

This definition is for informational and educational purposes only. Nothing on Finance Compass constitutes financial, investment, or trading advice. Always conduct your own research and consult a qualified professional before making financial decisions.