Capital Asset Pricing Model
Also known as: CAPM
Sharpe and Lintner's model relating expected return to systematic risk.
CAPM relates the expected return of an asset to its systematic risk via the equation E(R) = Rf + β(E(Rm) - Rf), where beta measures the asset's covariance with the market portfolio. Developed independently by William Sharpe, John Lintner, and Jan Mossin in the early-to-mid 1960s building on Markowitz's portfolio theory, the model provides a theoretical foundation for risk-adjusted pricing. Empirical performance has been substantially challenged — Fama and French's three-factor and five-factor extensions emerged precisely because CAPM beta alone explains less of cross-sectional return variation than the model predicts — but it remains foundational in finance education and the source of widely-used concepts like systematic versus idiosyncratic risk.
Core components
- Risk-free rate
- Market risk premium
- Beta (sensitivity to market returns)
- Security market line
- Assumption of efficient markets and homogeneous expectations
Primary use case
Estimating cost of equity for valuation; risk-adjusted performance measurement; academic finance teaching foundation.
Common criticisms
- Empirical predictions weak — beta alone explains less cross-sectional variation than predicted
- assumptions (efficient markets, homogeneous expectations, single-period horizon) are unrealistic
- superseded for many applications by Fama-French multifactor models.
Lineage
- Child of
- Modern Portfolio Theory
- Siblings
- Modern Portfolio Theory, Efficient Market Hypothesis, Fama-French models
- Derived from
- Modern Portfolio Theory