Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model · Also known as: Capital Asset Pricing Model, Sharpe-Lintner CAPM, security market line, Sermaye Varlıkları Fiyatlama Modeli
The Capital Asset Pricing Model (CAPM), developed by William Sharpe and John Lintner in the mid-1960s, links the expected return of an asset to its systematic risk, measured by beta. It states that in equilibrium investors are rewarded only for risk that cannot be diversified away: the expected excess return of an asset is proportional to the expected excess return of the market, with beta as the constant of proportionality. CAPM underpins the cost of equity, performance benchmarking, and a vast body of asset-pricing research.
Read the full method
Sign in with a free account to read this section.
Method map
The neighbourhood of related methods — select a node to explore.
When to use it
Use CAPM to estimate the cost of equity for discounting cash flows in valuation and capital budgeting, to set a risk-adjusted benchmark (the security market line) for evaluating portfolio or fund performance via alpha, and as the conceptual foundation for separating systematic from diversifiable risk. It assumes investors are mean-variance optimizers in a single period, can borrow and lend at the risk-free rate, and face frictionless markets with a common information set — strong assumptions that rarely hold exactly. Empirically, the single market factor explains returns imperfectly, which is why multifactor extensions (Fama-French, APT-style factor models) are preferred when accuracy matters; CAPM remains the baseline because of its simplicity and interpretability.
Strengths & limitations
- Provides a simple, intuitive link between systematic risk (beta) and expected return.
- Yields a practical estimate of the cost of equity used throughout corporate finance and valuation.
- Defines a clear risk-adjusted benchmark (the security market line and Jensen's alpha) for performance evaluation.
- Forms the theoretical foundation for the distinction between diversifiable and non-diversifiable risk.
- Relies on strong, unrealistic assumptions (frictionless markets, unlimited risk-free borrowing, mean-variance investors).
- A single market factor explains the cross-section of returns poorly; size, value, and momentum anomalies persist.
- Beta is estimated with error and is unstable over time, making expected-return estimates imprecise.
- The true market portfolio is unobservable (Roll's critique), so tests of CAPM are joint tests of the chosen proxy.
Frequently asked
What is beta in the CAPM?
Beta measures an asset's systematic risk — how strongly its return moves with the market. It is the covariance of the asset's return with the market return divided by the market variance. A beta of 1 means the asset moves with the market; above 1 amplifies market moves, below 1 dampens them. CAPM prices only this systematic risk.
Why does CAPM ignore diversifiable risk?
Because investors can eliminate company-specific risk by holding a diversified portfolio, the market does not reward bearing it. Only systematic risk — the part common to all assets that cannot be diversified away — is compensated, which is why expected return depends on beta alone in the model.
Does CAPM actually hold empirically?
Imperfectly. The single market factor leaves systematic patterns (size, value, momentum) unexplained, beta is unstable, and the true market portfolio is unobservable (Roll's critique). These shortcomings motivated multifactor models like Fama-French, though CAPM remains the standard baseline for its simplicity.
What is Jensen's alpha?
Jensen's alpha is the intercept from regressing an asset's excess return on the market's excess return. Under CAPM it should be zero; a significantly positive alpha is interpreted as risk-adjusted outperformance and a negative alpha as underperformance, subject to estimation error and the chosen risk model.
Sources
- Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425–442. DOI: 10.1111/j.1540-6261.1964.tb02865.x ↗
- Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. The Review of Economics and Statistics, 47(1), 13–37. DOI: 10.2307/1924119 ↗
How to cite this page
ScholarGate. (2026, June 2). Capital Asset Pricing Model. ScholarGate. https://scholargate.app/en/finance/capm
Which method?
Set this method beside its closest kin and read them side by side — the library lays the books on the table; the choice is yours.
- Factor Risk ModelFinance↔ compare
- OLS RegressionEconometrics↔ compare