Investments
CAPM and beta
CAPM estimates the return investors require for a risky asset from beta and the market risk premium.
Definition
The capital asset pricing model prices the relationship between systematic risk and expected return. Only systematic risk, the part that cannot be diversified away, is rewarded. Beta measures how sensitive an asset is to movements in the market portfolio.
The model gives a required return: the risk-free rate plus a premium for each unit of market risk carried.
Intuition
Investors are not paid for risk they could have diversified away for free. They are paid for the risk that remains when they hold the market.
When to use it
- Estimating the cost of equity inside WACC.
- Setting a hurdle rate for a security or a well-diversified portfolio.
When not to use it
- Valuing a private, undiversified holding where idiosyncratic risk is not diversifiable for the owner.
- As a precise prediction: beta is estimated and unstable over time.
Formula
Capital asset pricing model
E(R) = Rf + B × (Rm − Rf)
- Rf
- Risk-free rate
- B
- Beta: sensitivity to the market
- Rm
- Expected market return
Formula
Beta
B = Cov(Ra, Rm) ÷ Var(Rm)
Standardised covariance of the asset with the market.
Worked example
Required return for a share
Risk-free rate 4%; expected market return 10%; beta 1.3.
- 1
Market risk premium
10% − 4% = 6%.
- 2
Beta premium
1.3 × 6% = 7.8%.
- 3
Add the risk-free rate
4% + 7.8% = 11.8%.
An investor should require 11.8% from this share. If it is expected to return less, it is not attractive at that risk.
Common mistakes
- Using the total return instead of the excess return over the risk-free rate.
- Estimating beta from too short or too volatile a window.
- Assuming CAPM captures all priced risk factors.
How it connects
is used in
The source appears as an input to the target.
- Cost of capital (WACC): CAPM estimates the cost of equity inside WACC.
- Portfolio risk and diversification: CAPM prices the systematic risk a portfolio carries.
relates to
Useful to study together, in either order.
- Risk and return: Beta is systematic risk; volatility is total risk.
is an advanced form of
The source extends the target once the basics are secure.