The Capital Asset Pricing Model (CAPM) - Complete Guide
What is CAPM?
The Capital Asset Pricing Model is like a financial calculator that helps investors figure out:
How much return they should expect from a risky investment
Whether a stock is fairly priced or not
How risk and return are related
Think of it as a "risk-return GPS" - it tells you the expected destination (return) based on the route you
take (risk).
Key Assumptions of CAPM
CAPM is built on several simplifying assumptions (like assuming perfect weather for a road trip):
About Investors:
Rational behavior: All investors want maximum return for minimum risk (like smart shoppers)
Single period: Everyone invests for the same time period
Same information: All investors have access to identical information and make the same predictions
About Markets:
Perfect markets: No taxes, no transaction costs (like a frictionless marketplace)
Risk-free rate: Everyone can borrow/lend at the same risk-free rate
All assets tradeable: Every asset can be bought or sold publicly
Real-world note: These assumptions don't exist in reality, but they help create a useful theoretical
framework.
The Market Portfolio
What is it?
The market portfolio is like a giant basket containing every single investment in the economy,
weighted by their market values.
Example:
If the total stock market is worth $100 trillion:
Apple (worth $3 trillion) = 3% of market portfolio
Microsoft (worth $2.8 trillion) = 2.8% of market portfolio
A small company (worth $1 billion) = 0.001% of market portfolio
Key Insight:
Under CAPM, everyone should hold the same risky portfolio - the market portfolio. The only
difference between investors is how much they combine it with the risk-free asset.
The Security Market Line (SML)
The SML is the heart of CAPM. It's a straight line that shows the relationship between risk (beta) and
expected return.
The CAPM Formula:
Expected Return = Risk-free Rate + Beta × (Market Return - Risk-free Rate)
E(R) = Rf + β × (E(Rm) - Rf)
Example Calculation:
Risk-free rate (Rf) = 6% (Treasury bills)
Expected market return (Rm) = 14%
Stock's beta (β) = 1.2
Expected Return = 6% + 1.2 × (14% - 6%) = 6% + 1.2 × 8% = 6% + 9.6% = 15.6%
Understanding Beta (β)
Beta measures how much a stock moves relative to the overall market.
Beta Values:
β = 1: Stock moves exactly with the market (average risk)
β > 1: Stock is more volatile than market (high risk)
β < 1: Stock is less volatile than market (low risk)
β = 0: Stock has no correlation with market
Real Examples:
Technology stocks (like Tesla): β might be 1.5-2.0 (high risk, high potential return)
Utility companies: β might be 0.5-0.8 (low risk, steady returns)
Treasury bonds: β close to 0 (very low risk)
How Beta is Calculated:
Beta comes from the covariance between the stock and market:
β = Covariance(Stock Return, Market Return) / Variance(Market Return)
The GE Example Explained
The document uses General Electric (GE) to show how individual stock returns relate to market returns.
Key Principle:
The reward-to-risk ratio must be the same for all assets in equilibrium.
For GE:
Reward-to-Risk = Expected Return of GE / Covariance(GE, Market)
For Market:
Reward-to-Risk = Expected Market Return / Market Variance
These ratios must be equal, which leads to the CAPM formula.
Alpha - Finding Mispriced Securities
Alpha measures whether a stock is fairly priced according to CAPM.
Example from the Document:
Market return expected: 14%
Stock beta: 1.2
Risk-free rate: 6%
CAPM fair return: 6% + 1.2(14% - 6%) = 15.6%
Actual expected return: 17%
Alpha = 17% - 15.6% = 1.4%
What This Means:
Positive Alpha: Stock is underpriced (good buy)
Zero Alpha: Stock is fairly priced
Negative Alpha: Stock is overpriced (avoid or sell)
The Efficient Frontier and Capital Market Line
The Efficient Frontier:
A curved line showing the best possible risk-return combinations from different portfolio mixes.
Capital Market Line (CML):
A straight line from the risk-free rate that touches the efficient frontier at the market portfolio. This
represents the best possible portfolios combining the risk-free asset and market portfolio.
Investor Choices:
Conservative investor: Mostly risk-free assets + small amount of market portfolio
Aggressive investor: Borrow money to buy more of the market portfolio
Problems Solved
Problem 1:
Question: Portfolio expected return = 18%, risk-free rate = 6%, market return = 14%. What's the beta?
Solution:
18% = 6% + β × (14% - 6%)
18% = 6% + β × 8%
12% = β × 8%
β = 1.5
Problem 2:
Given: Risk-free rate = 4%, Market risk premium = 6%
Company A: Beta = 1.5, Forecasted return = 12%
Company B: Beta = 1.0, Forecasted return = 11%
Fair returns according to CAPM:
Company A: 4% + 1.5 × 6% = 4% + 9% = 13%
Company B: 4% + 1.0 × 6% = 4% + 6% = 10%
Analysis:
Company A: Forecasted 12% vs Fair 13% = -1% alpha (overpriced)
Company B: Forecasted 11% vs Fair 10% = +1% alpha (underpriced)
Extensions of CAPM
Fama-French Three-Factor Model
CAPM has limitations, so researchers added more factors:
Return = α + β₁(Market) + β₂(SMB) + β₃(HML) + error
SMB = Small Minus Big (company size effect)
HML = High Minus Low (book-to-market effect)
Factor Investing
Modern approach recognizing multiple risk factors:
Macroeconomic factors: Interest rates, inflation, GDP growth
Style factors: Value, growth, momentum, quality
Why Study CAPM?
Academic Reasons:
Foundation for modern finance theory
Framework for understanding risk-return relationships
Basis for performance evaluation
Practical Applications:
1. Portfolio Management: Asset allocation decisions
2. Performance Evaluation: Measuring fund manager skill
3. Corporate Finance: Cost of capital calculations
4. Security Analysis: Finding mispriced stocks
Real-World Limitations:
Market portfolio is unobservable
Assumptions are unrealistic
Returns don't always follow the model
Other factors matter beyond market risk
Single-Index Model
For practical implementation, CAPM often uses the single-index model:
Ri = αi + βi × RM + εi
Where:
Ri = Return on security i
αi = Alpha (intercept)
βi = Beta (sensitivity to market)
RM = Market return
εi = Random error
This model assumes all correlations between stocks come through their relationship with the market
index.
Key Takeaways
1. CAPM provides a benchmark for expected returns based on systematic risk (beta)
2. Higher risk should mean higher expected return - but only systematic risk is rewarded
3. Alpha indicates mispricing - positive alpha suggests undervaluation
4. The model has limitations but remains fundamental to finance
5. Practical applications include portfolio management and performance evaluation
Remember: CAPM is a theoretical model that provides useful insights, but real-world investing involves
many factors beyond what the model captures!
