Capital Asset Pricing Model (CAPM): Pricing Risk in Financial Markets

 

Understanding how assets are priced—and how risk is rewarded—is at the heart of modern finance. One of the most influential models that seeks to explain this relationship is the Capital Asset Pricing Model (CAPM).

Developed in the 1960s by William Sharpe, John Lintner, and Jan Mossin, CAPM is a cornerstone of financial economics and portfolio theory. It builds on Harry Markowitz’s Modern Portfolio Theory by introducing a precise, linear relationship between risk and expected return.

Let’s explore CAPM in depth—its mechanics, assumptions, strengths, and weaknesses.

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 What Is CAPM?

The Capital Asset Pricing Model describes how the expected return of a security is related to its systematic risk, as measured by a metric called beta (β).

 The CAPM Formula:

$$E(R_i) = R_f + \beta_i (E(R_m) - R_f)$$

Where:

• $E(R_i)$: Expected return of asset i

• $R_f$: Risk-free rate

• $\beta_i$: Asset's beta, or sensitivity to market returns

• $E(R_m)$: Expected return of the market portfolio

• $(E(R_m) - R_f)$: Market risk premium

This formula gives the theoretical expected return for a given level of systematic risk.

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 Core Intuition Behind CAPM

CAPM assumes that investors need to be compensated in two ways:

1. Time Value of Money (via the Risk-Free Rate)
   Even a risk-free asset like a government bond pays something—this is the baseline.

2. Risk Premium (via Beta and Market Premium)
   Investors demand extra return for taking on non-diversifiable (systematic) risk.

The model concludes that only systematic risk matters—idiosyncratic risk can be diversified away.

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 Understanding Beta (β)

• β = 1 → the asset moves in line with the market.

• β > 1 → the asset is more volatile than the market.

• β < 1 → the asset is less volatile than the market.

• β < 0 → the asset moves opposite to the market (e.g., gold).

Beta measures an asset’s exposure to market movements. It’s a statistical representation of risk relative to the market as a whole.

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 The Security Market Line (SML)

CAPM is graphically represented by the Security Market Line. This line plots:

• X-axis: Beta (systematic risk)

• Y-axis: Expected return

All assets should lie on the SML if they are fairly priced.

• Above the SML → underpriced (attractive to buy)

• Below the SML → overpriced (likely to underperform)

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 Assumptions of CAPM

CAPM relies on several strong theoretical assumptions:

1. Investors are rational and risk-averse

2. Markets are efficient (information is priced in instantly)

3. No taxes or transaction costs

4. Investors can borrow and lend at the risk-free rate

5. All investors have the same expectations

6. Asset returns are normally distributed

While not fully realistic, these assumptions provide a clean framework to understand the tradeoff between risk and return.

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 Applications of CAPM

CAPM is widely used in finance for:

• Cost of equity estimation (in DCF valuations)

• Performance benchmarking of mutual funds or ETFs

• Asset pricing and risk modeling

• Portfolio construction to compare risk-adjusted returns

• Evaluating alpha (the excess return above CAPM predictions)

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 Example: Using CAPM

Let’s say:

• Risk-free rate $R_f = 2\%$

• Market return $E(R_m) = 8\%$

• Asset beta $\beta = 1.2$

Then:

$$E(R_i) = 2\% + 1.2 \cdot (8\% - 2\%) = 2\% + 7.2\% = 9.2\%$$

This means the asset should return 9.2% annually to compensate for its risk.

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 Strengths of CAPM

✔ Simple and intuitive
✔ Provides a benchmark for required return
✔ Helps in asset pricing and portfolio selection
✔ Forms the basis for advanced models (e.g., APT, multifactor models)

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 Criticisms and Limitations

Despite its elegance, CAPM has been empirically challenged:

• Beta is unstable over time

• Returns aren’t always normally distributed

• CAPM doesn’t explain all market anomalies (e.g., momentum, size effect)

• Assumes unrealistic borrowing/lending conditions

• Ignores behavioral biases in real investors

These criticisms led to the development of multifactor models like:

• Fama-French 3-Factor Model (adds size and value)

• Carhart 4-Factor Model (adds momentum)

• Arbitrage Pricing Theory (APT) (uses multiple macro factors)

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 CAPM vs. Modern Portfolio Theory (MPT)

Feature	MPT	CAPM
Focus	Portfolio optimization	Asset pricing
Output	Efficient frontier	Expected return for given beta
Risk measure	Total risk (variance)	Systematic risk (beta)
Practical application	Diversification strategy	Valuation, discount rate estimation

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 Conclusion

The Capital Asset Pricing Model is a foundational tool in finance. It provides a systematic way to price risk and calculate expected returns based on market exposure. Though it has limitations and strong assumptions, it remains widely used in both academia and the financial industry.

Understanding CAPM helps investors:

• Make better allocation decisions

• Assess whether assets are fairly priced

• Evaluate portfolio performance in context

 "Risk and return are two sides of the same coin. CAPM shows us how they are priced together."