Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a financial theory that describes a linear relationship between the expected return of an asset and its systematic risk, represented by beta. Developed by William Sharpe in 1964, CAPM provides a framework for determining the appropriate required rate of return on an investment by accounting for the risk-free rate, the market risk premium, and the asset’s sensitivity to market movements. The model is commonly expressed as:

Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)

CAPM is widely applied in corporate finance for capital budgeting, portfolio management, and asset valuation. Despite certain assumptions—such as market efficiency and investor rationality—that may not always reflect real-world conditions, the model remains a cornerstone in understanding the trade-off between risk and return. Investment professionals use CAPM to assess whether securities are fairly priced, evaluate portfolio performance, and guide asset allocation decisions. Its focus on systematic risk helps clarify which risks can be mitigated through diversification and which are inherent to market exposure.

The CAPM formula is:

Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)

This equation estimates the return an investor should expect from an asset, considering the time value of money (the risk-free rate) and compensation for risk (beta times the market risk premium). It helps determine whether an asset offers a sufficient return relative to its risk.

Beta measures an asset’s sensitivity to market movements. It is typically calculated using regression analysis, where:

Beta = Covariance (Asset Return, Market Return) / Variance (Market Return)

If an asset has a beta of 1, it moves in line with the market. A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 suggests less volatility. Historical stock price data is usually used for this calculation.

CAPM relies on several core assumptions:

• All investors are rational and risk-averse.
• Markets are efficient and all information is freely available.
• Investors can borrow and lend at the risk-free rate.
• All investors have the same expectations about risk and return.
• There are no taxes or transaction costs.

These assumptions simplify the real world, which can limit CAPM’s accuracy. However, the model still provides a useful framework for thinking about risk and return.

CAPM plays a key role in determining the required rate of return for an investment. For businesses, this is critical when setting prices, evaluating capital investments, or valuing projects. For example:

• In capital budgeting, firms use CAPM to calculate the discount rate for future cash flows.
• In stock valuation, CAPM helps assess if a stock is overvalued or undervalued based on its expected return relative to risk.

Ultimately, it helps companies and investors make more informed decisions by quantifying the trade-off between risk and return.