Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Overview

CAPM (Sharpe, 1964; Lintner, 1965) establishes a linear relationship between systematic risk and expected return. The model states that the expected return on any asset equals the risk-free rate plus a premium for bearing market risk, scaled by the asset's beta.

When to Use

• Estimating required rate of return for equity valuation
• Calculating cost of equity in WACC
• Comparing asset risk via beta
• Evaluating portfolio performance against the Security Market Line (SML)

When NOT to Use

• When the asset has significant exposure to size, value, or other factors beyond market risk
• For illiquid or non-traded assets where beta estimation is unreliable
• When market portfolio proxy is questionable (Roll's critique)

Assumptions

IRON LAW: CAPM only prices SYSTEMATIC risk — diversifiable (unsystematic)
risk earns NO premium. An asset's expected return depends solely on its
beta with the market portfolio.

Key assumptions:

1. Investors are mean-variance optimizers with homogeneous expectations
2. A risk-free asset exists for unlimited borrowing and lending
3. Markets are frictionless — no taxes, transaction costs, or short-selling constraints
4. All assets are infinitely divisible and publicly traded

Methodology

Step 1 — Identify Inputs

• Risk-free rate (Rf): government bond yield matching investment horizon
• Market return E(Rm): historical average or forward-looking estimate
• Beta: regression of asset returns against market returns