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The Capital Asset Pricing Model (CAPM) is an equilibrium model determining the required return of any asset solely from its systematic risk: E[rᵢ] = rₓ + βᵢ(E[rₘ] − rₓ). The Security Market Line (SML) graphs this relationship — correctly priced assets lie on the SML; assets above are underpriced (offering return above what risk warrants) and those below are overpriced. CAPM's core insight is that because all other risk can be diversified away in a large portfolio, only beta — the covariance with the market — earns a compensation. Despite restrictive assumptions (homogeneous expectations, no taxes, perfect markets), CAPM remains the dominant framework in practice for estimating the cost of equity capital.
Estimate a stock's beta from historical returns and apply CAPM to compute the cost of equity for discounting cash flows in a valuation model. Plot stocks on the SML and identify apparent mispricings. Study the empirical literature — the size and value factors reveal where CAPM fails cross-sectionally.
CAPM builds directly on portfolio theory. You learned from the efficient frontier that adding assets to a portfolio reduces risk through diversification — but only up to a point. Some risk cannot be diversified away no matter how many assets you hold, because it comes from economy-wide forces (recessions, interest rate changes, inflation) that affect all assets simultaneously. CAPM calls this systematic risk. The remaining risk — unique to a single company — is idiosyncratic risk, and a well-diversified portfolio eliminates it entirely.
The punchline is a pricing implication: if rational investors can eliminate idiosyncratic risk for free by diversifying, they will not demand extra return for bearing it. The market will price assets so that only systematic risk earns a return premium. This is why CAPM collapses the entire risk of an asset into a single number: beta (β), defined as the covariance of the asset's returns with the market portfolio, divided by the variance of the market. Beta is a pure measure of systematic risk — how much the asset moves with the overall market.
The CAPM equation is then: E[rᵢ] = rᶠ + βᵢ(E[rₘ] − rᶠ). Read it as: the expected return on asset i equals the risk-free rate (what you earn for waiting, with no risk) plus beta times the market risk premium (what the market pays per unit of systematic risk). If an asset has β = 0, it moves independently of the market, so you only earn the risk-free rate. If β = 2, the asset is twice as sensitive to market swings and commands twice the market risk premium.
The Security Market Line (SML) is the graph of this relationship — expected return on the y-axis, beta on the x-axis. In equilibrium, every correctly priced asset lies exactly on the SML. A stock plotting above the line has a positive alpha: it offers more return than its beta justifies. In theory, investors would buy it until the price rises enough to push expected return back to the SML. A stock below the line is overpriced and would be sold. Alpha — deviation from the SML — is the central concept in active portfolio management.
CAPM's assumptions are strong: homogeneous expectations, perfect markets, a single period, no taxes or transaction costs, and a market portfolio that includes every investable asset in the world. In practice, we use an index like the S&P 500 as a rough proxy for the market, and the empirical track record is mixed. Fama and French showed that small-cap and value stocks earn returns that CAPM cannot explain with beta alone. Yet CAPM persists as the baseline for cost-of-equity estimation in corporate finance — its clarity and simplicity make it hard to replace even when its predictions are imperfect.