1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion


Pronounced as though it were spelled "cap-m", this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities.

CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.


The commonly used formula to describe the CAPM relationship is as follows:

Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

Required (or expected) Return = 5% + (12% - 5%)*1.9
Required (or expected) Return = 18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized.


Financial Concepts: Conclusion
Related Articles
  1. Investing

    The Capital Asset Pricing Model: an Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  2. Investing

    The Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  3. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  4. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
  5. Investing

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
  6. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  7. Investing

    Beta: Know The Risk

    Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
  8. Investing

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
Frequently Asked Questions
  1. When are Beneficiaries of a Will Notified?

    Learn when the beneficiaries of a will must be notified, and understand how this requirement varies depending on whether ...
  2. Why Does Larry Page Pay Himself a $1 Salary?

    Google co-founder Larry Page continues to take an annual salary of only $1 as chief executive officer.
  3. What is Common Stock and Preferred Stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ...
  4. Can CareCredit be Used for Family Members?

    Learn more about the available options that CareCredit offers to pay for out-of-pocket medical procedures with little to ...
Trading Center