CAPM

CAPM, the Capital Asset Pricing Model, describes the relationship between the expected return of an asset and its systematic risk relative to the market. The expected return on asset i is E[R_i] = R_f + beta_i (E[R_m] - R_f). R_f is the risk-free rate, E[R_m] the expected return on the market portfolio, and beta_i its sensitivity to market movements. Beta is Cov(R_i, R_m) / Var(R_m). The market portfolio is a theoretical bundle of investable assets weighted by market value, representing aggregate market risk. The term (E[R_m] - R_f) is the market risk premium.

Interpretation: The model implies that the only part of an asset's risk that commands a reward is its systematic risk, as measured by beta. Diversifiable, idiosyncratic risk is eliminated through diversification, leaving investors compensated for market risk. The security market line (SML) plots expected returns against beta, illustrating required returns for different risk exposures.

Assumptions and uses: CAPM is a single-period model built on frictionless markets, no taxes or transaction costs, and homogeneous expectations. Investors hold diversified portfolios and require compensation for bearing systematic risk. Practitioners use CAPM to estimate a firm's cost of equity in calculating WACC and to price assets relative to the market.

Limitations and extensions: Empirical tests show a positive relation between beta and returns but limited explanatory power and instability of beta estimates. Critics point to mismatches between the market proxy and the true market, and to time-varying risk premia. Extensions include multi-factor models such as the Fama-French three-factor model, which adds size and value factors. Despite limitations, CAPM remains a foundational baseline in asset pricing and corporate finance.