Capital Asset Pricing Model (CAPM)
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 volatile than the market (amplifies moves) | Growth tech stocks |
| Beta < 1.0 | Less volatile than the market (dampens moves) | Utility stocks |
| Beta = 0 | No correlation to market movements | Risk-free asset |
| Negative beta | Moves opposite to the market | Gold (sometimes) |
- A stock with a beta of 1.5 is expected to rise 15% when the market rises 10%, and fall 15% when the market drops 10%
- Beta measures systematic risk only; it does not capture company-specific risk
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; actual return exceeds what CAPM predicts for its beta | Buy |
| On the SML | Fairly valued; return matches the risk level | Hold |
| Below the SML | Overvalued; actual return is less than what CAPM predicts 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.