Capital Asset Pricing Model

Developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, the Capital Asset Pricing Model is one of the foundational theories of modern finance. It provides a mathematically precise answer to the question: given the risk of this asset, what return should a rational investor require to hold it?

CAPM begins with the premise that investors are rational and hold diversified portfolios. Under this assumption, the only risk that matters for pricing is systematic risk — the portion of an asset's risk that cannot be diversified away because it is driven by economy-wide factors. This systematic risk is quantified by beta. An asset with a beta of 1.0 moves in lockstep with the market; a beta of 1.5 implies 50% more sensitivity to market swings.

The CAPM equation states that an asset's expected return equals the risk-free rate plus beta multiplied by the equity risk premium (the expected excess return of the market over the risk-free rate). This creates a straight line in return-beta space known as the Security Market Line. Assets that plot above the line are generating returns above what their beta predicts (positive alpha); assets below the line are underperforming their risk-adjusted expectation.

Despite its elegance, CAPM has well-documented empirical shortcomings. The model predicts that only beta explains cross-sectional differences in expected returns, yet decades of research have identified other factors — size, value, momentum, profitability — that also predict returns. This has led to multi-factor extensions such as the Fama-French three-factor and five-factor models.

Nevertheless, CAPM remains widely used in corporate finance for estimating the cost of equity capital in discounted cash flow models, in performance attribution to calculate Jensen's Alpha, and as a conceptual foundation for understanding why diversification reduces risk and why markets compensate investors only for bearing systematic, unavoidable risk.