Quick Answer
CAPM prices assets on systematic risk (beta) only: Expected Return = Rf + Beta x (Rm - Rf). The Security Market Line plots this relationship; assets above it are undervalued, assets below it are overvalued. The exam's biggest trap: CAPM uses beta, while the Sharpe ratio uses standard deviation (total risk).
The CAPM is the starting point for capital market theory because it defines the fundamental relationship between risk and expected return: the building block for everything that follows.
The Core Idea
- CAPM describes the relationship between systematic risk (market risk) and the expected return for an asset
- Investors are compensated only for systematic risk (the risk that cannot be diversified away)
- Unsystematic risk (company-specific risk) earns no additional return because it can be eliminated through diversification
The CAPM Formula
Breaking this down:
| Component | What It Represents | Example |
|---|---|---|
| Risk-Free Rate (Rf) | Return on a risk-free asset (typically U.S. Treasury bills) | 4% |
| Beta | Sensitivity of the asset's returns to market movements | 1.2 |
| Market Return (Rm) | Expected return of the overall market | 10% |
| Market Risk Premium (Rm - Rf) | Extra return investors demand for bearing market risk | 6% |
Think of it this way: You start with the guaranteed return (risk-free rate), then add a bonus for taking on market risk. The bigger the beta, the bigger the bonus, because the asset swings more with the market.
Example calculation:
- Expected Return = 4% + 1.2 x (10% - 4%) = 4% + 1.2 x 6% = 4% + 7.2% = 11.2%
Understanding Beta
Beta measures how much an asset's price moves relative to the overall market:
| Beta Value | Meaning | Example |
|---|---|---|
| Beta = 1.0 | Moves in line with the market | S&P 500 index fund |
| Beta > 1.0 | More sensitive to market moves (amplifies them) | Growth tech stocks |
| Beta < 1.0 | Less sensitive to market moves (dampens them) | Utility stocks |
| Beta = 0 | No systematic sensitivity to market movements | Risk-free asset |
| Negative beta | Moves opposite to the market | Gold (sometimes) |
- A stock's beta scales its sensitivity to the market's excess return over the risk-free rate, not its raw percentage move; a beta of 1.5 means the stock's return responds about 1.5 times as much as the market's return to a given market move (see the CAPM formula above for the actual expected-return calculation)
- Beta measures systematic risk only; it does not capture company-specific risk. A low-beta stock can still have high total volatility from company-specific swings, since beta and standard deviation measure different things
Exam Tip: Gotchas
- CAPM uses beta (systematic risk). The Sharpe ratio uses standard deviation (total risk). The exam frequently tests which risk measure each model uses. CAPM = beta, Sharpe = standard deviation.
The Security Market Line (SML)
The Security Market Line is the graphical representation of CAPM. It plots expected return (y-axis) against beta (x-axis).
- The SML starts at the risk-free rate (where beta = 0) and slopes upward
- Every point on the SML represents a fairly priced asset given its level of systematic risk
Using the SML to identify mispriced securities:
| Position | Meaning | Action |
|---|---|---|
| Above the SML | Undervalued; the security's expected return exceeds what CAPM requires for its beta | Buy |
| On the SML | Fairly valued; expected return matches the risk level | Hold |
| Below the SML | Overvalued; the security's expected return is less than what CAPM requires for its beta | Sell or avoid |
Exam Tip: Gotchas
- An asset above the SML is undervalued (higher return than expected for its risk level), not overvalued. This is counterintuitive because "above" sounds like "overpriced."
- The market risk premium is (Rm - Rf), not just Rm. The risk-free rate must be subtracted first.
Key Assumptions of CAPM
- Investors are rational and risk-averse
- Markets are efficient (no transaction costs, taxes, or restrictions)
- All investors have the same time horizon and expectations
- Investors can borrow and lend at the risk-free rate
- Only systematic risk is rewarded with higher expected returns
Exam Tip: Gotchas
- CAPM assumes investors are only compensated for systematic risk. Unsystematic risk can be diversified away and earns no premium. If a question asks what type of risk CAPM addresses, the answer is always systematic (market) risk.
What Should You Check on Exam Day?
- CAPM uses beta (systematic risk) only; the Sharpe ratio uses standard deviation (total risk). Know which model uses which measure.
- The formula is Expected Return = Rf + Beta x (Rm - Rf); the market risk premium is (Rm - Rf), not Rm alone.
- On the Security Market Line: above = undervalued (buy), below = overvalued (sell). "Above" sounds like overpriced but means the opposite.
- Only systematic risk is compensated; unsystematic risk earns no premium because diversification removes it.
- Key CAPM assumptions: rational, risk-averse investors, efficient markets, shared expectations, and borrowing and lending at the risk-free rate.