Capital Asset Pricing Model (CAPM) Explained

Learn what the Capital Asset Pricing Model (CAPM) means, how it calculates expected returns, and why it matters in finance and valuation.

The Capital Asset Pricing Model (CAPM) is a financial framework used to estimate the expected return of an investment based on its risk relative to the market. It is used to illustrate how much return an investor may expect for taking on additional risk compared to a risk-free investment. CAPM is widely used in portfolio management, corporate finance, and stock valuation.

By linking risk and return through a structured formula, CAPM offers a clear way to compare investments, assess pricing efficiency, and make informed decisions about allocating capital.

The Capital Asset Pricing Model describes the relationship between systematic risk and expected investment return. Systematic risk represents market-wide forces that investors cannot eliminate through diversification. CAPM states that investors should be compensated only for this type of risk, not for unsystematic or firm-specific risk.

The model provides a consistent method to estimate returns by combining:

• The risk-free return
  

• The investment’s sensitivity to market movements (beta)
  

• The expected market return

CAPM is foundational in modern finance due to its simplicity and deep use in valuation.

The theory behind CAPM is based on the concept that investors demand higher returns for taking additional risk. It assumes that markets are efficient, investors are rational, and all assets are priced fairly according to their risk profile. The model draws from portfolio theory that emphasises diversification and market equilibrium.

CAPM explains that only systematic risk influences expected returns. This means stocks more sensitive to market movements require higher expected returns than less sensitive ones.

The CAPM formula helps calculate the expected return of an investment using the following expression:

• Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)

The key components are:

• Risk-Free Rate: Return on government securities
  

• Beta: Sensitivity of the investment to market movements
  

• Market Return: Expected return of the overall market
  

• Market Risk Premium: Difference between market return and the risk-free rate
  

This formula allows investors to estimate fair expected returns relative to risk.

Components of the CAPM Formula

The main components include:

• Risk-Free Rate: Represents the baseline return with minimal risk, such as government bonds.
  

• Beta (β): Measures how much the investment’s return moves in relation to the market.
  

• Expected Market Return: The anticipated return from the market index or benchmark.
  

• Market Risk Premium: The extra return expected from the market over the risk-free rate.
  

Understanding these components is essential for accurate calculation.

CAPM Calculation Example

Consider a stock with the following details:

• Risk-Free Rate: 4%
  

• Expected Market Return: 10%
  

• Beta: 1.2

Step-by-step calculation:

1. Market Risk Premium = 10% – 4% = 6%
   

2. Adjust for beta = 1.2 × 6% = 7.2%
   

3. Expected Return = 4% + 7.2% = 11.2%

This implies an expected return of 11.2% for taking on the stock’s level of risk.

CAPM is used across financial decision-making because it provides a clear and structured method to assess expected returns.

Key applications include:

• Investment Appraisal: Offers a way to assess return expectations based on risk factors.
  

• Portfolio Management: Assists in constructing diversified portfolios based on risk-return expectations.
  

• Cost of Equity Calculation: Used in corporate finance to estimate the cost of equity for valuation models.
  

• Performance Evaluation: Compares actual returns against expected returns to judge performance.

Portfolio Management

CAPM is used to analyse suitable risk levels for portfolios. By comparing expected returns to the risk-free rate and adjusting for beta, they build portfolios that match their risk preferences.

Stock Valuation

Analysts use CAPM to calculate the expected return required by investors. This expectation influences stock pricing models and helps determine whether a stock is overvalued or undervalued.

CAPM relies on certain foundational assumptions. These help simplify calculations but also introduce limitations.

Key assumptions include:

• Investors have identical expectations about returns.
  

• Markets are efficient and information is freely available.
  

• Investors can borrow and lend at the risk-free rate.
  

• There are no taxes or transaction costs.
  

• Returns follow a normal distribution.
  

• All investors aim to maximise returns and minimise risk.

These assumptions create a structured model for pricing risk and return.

CAPM provides a structured and practical method for estimating expected returns based on market risk. It forms the basis for many investment decisions, valuation models, and portfolio strategies. While the model has limitations, its simplicity and widespread acceptance make it a valuable tool for understanding risk–return relationships.

Key takeaways:

• CAPM explains how systematic risk affects expected returns.

• The formula uses risk-free rate, beta, and market risk premium.

• It helps in portfolio management, stock pricing, and cost of equity calculations.

• Assumptions simplify the model but introduce limitations.

• CAPM is most useful when applied with awareness of its constraints.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.