Definition
CAPM establishes a linear relationship between an asset's expected return and its beta (systematic risk exposure). The model assumes diversified portfolios eliminate unsystematic risk, so only market risk is compensated. Despite theoretical limitations (single-factor, assumes efficient markets), CAPM remains the most widely used model for estimating cost of equity.
functions Formula
E(R) = Rf + β × (Rm − Rf)
lightbulb Example
Risk-free rate 3.5%, market return 9.5%, beta 1.3. Expected return = 3.5% + 1.3 × (9.5% - 3.5%) = 3.5% + 7.8% = 11.3%.
verified_user Key Points
- Foundation for estimating cost of equity
- Beta measures sensitivity to market movements
- Single-factor model—Fama-French adds size and value factors
- Assumes investors hold diversified portfolios