What is CAPM? The Capital Asset Pricing Model Explained

CAPM defines the relationship between systematic risk and expected return for assets, particularly stocks. It is used to price risky securities.

The Capital Asset Pricing Model (CAPM) is a framework used to determine the theoretically required rate of return of an asset to justify adding it to a diversified portfolio. Introduced by William Sharpe and others in the 1960s, it separates risk into two categories: systematic risk (market risk) and idiosyncratic risk (specific to a company). CAPM argues that investors should only be compensated for systematic risk, as idiosyncratic risk can be diversified away.

The CAPM formula is: $E(R_i) = R_f + \beta_i (E(R_m) - R_f)$. In this equation, $E(R_i)$ is the expected return, $R_f$ is the risk-free rate, $\beta_i$ is the asset's sensitivity to the market, and $(E(R_m) - R_f)$ is the market risk premium. If the 10-year Treasury yield is 4%, the market risk premium is 6%, and a stock like Apple (AAPL) has a beta of 1.1, the expected return is $0.04 + 1.1(0.06) = 10.6\%$.

The SML is the visual representation of CAPM, plotting expected return against beta. Assets that plot above the SML are considered undervalued because they offer a higher return for their level of risk. Conversely, assets below the line are overvalued. While CAPM is a staple of 2021 finance textbooks, its reliance on a single factor (beta) has been challenged by multi-factor models like the Arbitrage Pricing Theory (APT), which adds size and value as risk dimensions.