What Is the CAPM (Capital Asset Pricing Model)?

The core formula of the Capital Asset Pricing Model (CAPM) is as follows.

Expected return = risk-free rate + β × (expected market return − risk-free rate)

Here, (expected market return − risk-free rate) is called the 'market risk premium.' In other words, the CAPM says: 'the fair expected return of an asset = the return you can earn safely + the extra reward for however much that asset is exposed to market risk.'

Risk-free rate (Rf): the return on an asset with almost no risk. It is usually approximated by the yield on a long-term government bond (e.g., the 10-year).

Beta (β): a value showing how much the asset swings relative to the overall market. If β=1 it moves in line with the market, if β>1 it moves more than the market, and if β<1 it moves less.

Market risk premium: the portion added on top of the risk-free return as compensation for investing in the risky market.

For example, suppose the risk-free rate is 3%, the expected market return is 8%, and a stock has a β of 1.2.

Expected return = 3% + 1.2 × (8% − 3%) = 3% + 1.2 × 5% = 3% + 6% = 9%

Since β is 1.2 and the stock swings more than the market, you would demand a higher expected return of 9%, above the market average (8%). Conversely, for a defensive asset with a β of 0.6, it would be lower: 3% + 0.6×5% = 6%.

The CAPM was developed by William Sharpe (Sharpe, 1964), Lintner (1965), and others, and Sharpe received the Nobel Prize in Economics in 1990.

However, the CAPM assumes that 'beta alone explains all risk,' whereas later research (such as Fama-French) found that in reality other factors like size, value, and momentum also affect returns. The CAPM is a starting point for understanding expected return, not a precise forecasting tool.