Capital Asset Pricing Model (CAPM)
CAPM describes the relationship between systematic risk (beta) and expected return: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate).
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Definition
CAPM describes the relationship between systematic risk (beta) and expected return: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate).
Use case
Used in portfolio management workflows, analysis, and technical interviews.
Judgment check
Useful only when the assumptions and inputs behind the metric are understood.
Deep dive
How to think about Capital Asset Pricing Model (CAPM)
CAPM revolutionized finance (Sharpe, Markowitz, others — Nobel 1990). The Security Market Line (SML) plots expected return against beta. Assets above the SML are undervalued; below are overvalued. CAPM underpins cost of equity calculations in corporate finance, though empirical tests show mixed results (size, value, and momentum factors also matter).
Example: Risk-free rate = 4%, Expected market return = 10%, Stock beta = 1.2. CAPM expected return = 4% + 1.2 × (10% - 4%) = 4% + 7.2% = 11.2%. If the stock is priced to return 13%, it may be undervalued relative to its risk.
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Definition, example, and interview framing
CAPM describes the relationship between systematic risk (beta) and expected return: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate).
Risk-free rate = 4%, Expected market return = 10%, Stock beta = 1.2. CAPM expected return = 4% + 1.2 × (10% - 4%) = 4% + 7.2% = 11.2%. If the stock is priced to return 13%, it may be undervalued relative to its risk.
In an interview, define Capital Asset Pricing Model (CAPM), explain where it appears in a real finance workflow, then name one assumption or limitation that a reviewer should check.
FAQ
Frequently Asked Questions
What is Capital Asset Pricing Model (CAPM)?
CAPM describes the relationship between systematic risk (beta) and expected return: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate).
How is Capital Asset Pricing Model (CAPM) used in finance?
CAPM revolutionized finance (Sharpe, Markowitz, others — Nobel 1990). The Security Market Line (SML) plots expected return against beta. Assets above the SML are undervalued; below are overvalued. CAPM underpins cost of equity calculations in corporate finance, though empirical tests show mixed results (size, value, and momentum factors also matter).
Can you give an example of Capital Asset Pricing Model (CAPM)?
Risk-free rate = 4%, Expected market return = 10%, Stock beta = 1.2. CAPM expected return = 4% + 1.2 × (10% - 4%) = 4% + 7.2% = 11.2%. If the stock is priced to return 13%, it may be undervalued relative to its risk.