What you will learn
- State the CAPM formula and what each part means
- Explain why only systematic risk (beta) earns a return
- Use the CAPM to compute an asset's expected return
- Read the security market line and spot mispriced assets
The capital market line priced whole efficient portfolios. But what return should a single stock earn for its risk? The Capital Asset Pricing Model, or CAPM, answers exactly that, and it is one of the most influential formulas in finance. It won a Nobel Prize, it is how analysts estimate the cost of equity, and it rests on the beta you met in Unit 5.
The Capital Asset Pricing Model and security market line (Ryan O'Connell)
Explains the CAPM formula and the security market line together. Focus on how beta drives expected return.
Only systematic risk is paid for
Recall the central lesson of diversification: unsystematic, company-specific risk can be removed for free by holding many assets, so the market does not reward you for bearing it. Only systematic risk, the market-wide risk you cannot diversify away, earns a higher expected return. The CAPM takes this idea and turns it into a precise formula. It says an asset's expected return depends on one thing only: how much systematic risk it carries, measured by its beta.
The formula in symbols
- rf = the risk-free rate
- β = the asset's sensitivity to the market
- rm = expected return of the market
- rm − rf = the market risk premium
Beta scales the market risk premium: an asset with beta 1 earns the full premium, an asset with beta 2 earns twice the premium, and an asset with beta 0.5 earns half. In plain words: start at the risk-free rate and add a reward proportional to how much market risk you take on.
Key terms
- Beta (β)
- How sensitive an asset is to market moves. Beta 1 moves with the market, above 1 amplifies it, below 1 dampens it.
- Market risk premium
- The market's expected return minus the risk-free rate, rm - rf, the reward for bearing market risk.
- Security market line
- The straight line plotting CAPM expected return against beta. Every fairly priced asset lies on it.
Computing an expected return with CAPM
The risk-free rate is 3 percent, the expected market return is 8 percent, and a stock has a beta of 1.2. What expected return does the CAPM predict?
- Find the market risk premium. rm minus rf is 8 percent minus 3 percent, which is 5 percent.
- Scale it by beta. 1.2 times 5 percent is 6 percent.
- Add the risk-free rate. 3 percent plus 6 percent is 9 percent.
Why it matters: The stock earns more than the market's 8 percent because its beta of 1.2 means it carries more systematic risk, and more systematic risk demands more reward.
Apply the CAPM
The risk-free rate is 2 percent, the expected market return is 10 percent, and a stock has a beta of 0.8. What expected return does the CAPM predict, in percent?
The security market line
If you plot the CAPM expected return on the vertical axis against beta on the horizontal axis, you get a straight line called the security market line. It starts at the risk-free rate, where beta is zero, and slopes upward at the rate of the market risk premium. Every asset that is fairly priced sits exactly on this line. This gives a useful way to think about mispricing. An asset offering a higher return than its beta warrants sits above the line and looks underpriced, a bargain with positive alpha. An asset offering less than its beta warrants sits below the line and looks overpriced. Alpha, in fact, is just an asset's distance above or below the security market line.
The CAPM says your reward should match one thing only: the market risk you cannot diversify away. Everything above that line is alpha, and alpha is rare.
CAPM explained (Financial Edge Training)
A clean second walkthrough of the formula and its use in estimating required returns. Good reinforcement.
Bargain or not?
A stock has a beta of 1.0, and the CAPM says a beta-1.0 stock should return 8 percent. Your analysis suggests this stock will actually return 11 percent. Where does it sit relative to the security market line?
The stock is expected to return 11 percent while its beta warrants only 8 percent, so it sits 3 percent above the security market line. That gap is positive alpha, marking it as underpriced according to your analysis.Uses and honest limitations
The CAPM has a concrete job you have already met: it is the standard way to estimate the cost of equity, the return shareholders require, which feeds into the discount rate used in the discounted cash flow valuation of Unit 3. But it is not the last word. Decades of evidence show that beta alone does not fully explain real returns, which is why researchers added other drivers like company size and value, the factor models you will study later in this unit. The CAPM also leans on the same shaky assumptions as modern portfolio theory: efficient markets, normal returns, and a single market portfolio no one can actually observe. Treat it as a foundational and useful approximation, not a law of nature.
Why beta, not total risk?
In your own words, explain why the CAPM ties expected return to beta (systematic risk) rather than to an asset's total volatility.
Write an answer before comparing it with the model response.
Model answer
An asset's total volatility includes both systematic risk, which comes from market-wide moves, and unsystematic risk, which is specific to the company. Unsystematic risk can be diversified away for free by holding many assets, so a rational market does not pay anyone to bear it. Only systematic risk remains once you diversify, and that is what beta measures. Since investors can be assumed to be diversified, the market rewards only the risk they cannot escape. That is why the CAPM ties expected return to beta rather than to total volatility, which would wrongly reward the diversifiable part.
The CAPM splits an asset's return into a market-driven part, from beta, and any leftover. That leftover is alpha. The next lesson examines alpha and beta head-on as tools for judging real investments and managers.