Capital Asset Pricing Model
Definition
A model that describes the relationship between systematic risk (beta) and expected return for assets, forming the foundation of modern portfolio theory.
Explanation
CAPM, developed by William Sharpe (1964), states that expected return equals the risk-free rate plus a risk premium proportional to the asset's beta. It implies that investors should only be compensated for systematic (non-diversifiable) risk. While academically foundational, CAPM has known limitations: it assumes a single risk factor (market beta), ignores size, value, and momentum effects, and empirical tests show a flatter security market line than predicted.
Formula
E(Ri) = Rf + βi × (E(Rm) - Rf)
Example
Risk-free rate is 4%, market expected return is 10%, and a stock has beta of 1.3.
E(Ri) = 4% + 1.3 × (10% - 4%) = 4% + 7.8% = 11.8%
CAPM predicts this stock should return 11.8% per year to compensate for its above-market systematic risk.
See This in Action
Explore how capital asset pricing model applies to real portfolios on Stoquity.
Start Free →