Capital Asset Pricing Model (CAPM): Understanding Risk and Expected Return

When evaluating investments, one of the most important questions is: “How much return should I expect for the risk I’m taking?”
The Capital Asset Pricing Model (CAPM) helps answer exactly that. It’s a foundational concept in modern finance that explains the relationship between expected return and systematic risk — the type of risk that affects the entire market and cannot be diversified away.

Core Idea

CAPM suggests that investors need to be compensated in two ways:

Time value of money — represented by the risk-free rate (for simply waiting and tying up money).

Risk premium — an additional return for taking on extra market risk.

The higher the risk compared to the overall market, the higher the expected return should be.

In Simple Terms

Think of CAPM as a fairness calculator for investments.
It tells you what return an asset should offer based on how risky it is compared to the market.
If the actual return is higher than the CAPM prediction, the asset may be undervalued (a good buy); if lower, it may be overvalued.

CAPM Formula
Expected Return (E[R])
=
𝑅
𝑓
+
𝛽
×
(
𝑅
𝑚
−
𝑅
𝑓
)
Expected Return (E[R])=R
f
​

+β×(R
m
​

−R
f
​

)

Where:

E[R] = Expected return on the asset

Rₓ = Risk-free rate (e.g., government bond yield)

β (Beta) = Sensitivity of the asset to market movements

Rₘ − Rₓ = Market risk premium (extra return investors expect for taking market risk)

Example

Suppose:

Risk-free rate = 3%

Market return = 9%

Beta of the stock = 1.2

𝐸
[
𝑅
]
=
3
%
+
1.2
×
(
9
%
−
3
%
)
=
3
%
+
7.2
%
=
10.2
%
E[R]=3%+1.2×(9%−3%)=3%+7.2%=10.2%

This means, according to CAPM, the investor should expect about a 10.2% return from this stock given its risk level.

Real-Life Application

A portfolio manager might compare several assets using CAPM to decide which ones offer a better risk-adjusted return.
For example, if two stocks both have an expected return of 10%, but one has a beta of 0.8 and the other 1.5, the first stock offers the same return with less risk — making it more attractive.

Common Misconceptions and Mistakes

CAPM doesn’t predict future returns perfectly: It’s a theoretical model assuming markets are efficient, which isn’t always true.

Beta changes over time: A company’s risk profile can shift with its industry or performance, so using outdated beta values can mislead results.

Ignores unsystematic risk: CAPM assumes investors already hold diversified portfolios, so it only accounts for market-wide risk, not company-specific events.

Related Queries Traders Often Search For

How is CAPM different from the Fama-French model?

What does beta mean in CAPM?

Why do investors use CAPM to calculate cost of equity?

What are the assumptions behind CAPM?

Can CAPM be used in forex or crypto trading?

Summary

The Capital Asset Pricing Model (CAPM) helps investors estimate a fair return based on the risk level of an asset.
It combines the risk-free rate, market return, and beta to determine what return compensates for market exposure.
While it’s a powerful tool for comparing investments, it’s most effective when used alongside other models that account for real-world factors like changing risk, taxes, and investor behavior.