Capital Asset Pricing Model (CAPM)

CAPM is the foundation of modern finance: it says the expected return on an asset equals the risk-free rate plus a risk premium proportional to the asset's systematic risk (beta). Formula: E[R] = Rf + β×(Rm − Rf). Example: If Rf = 3%, market return (Rm) = 10%, and a stock's beta = 1.3, expected return = 3% + 1.3×(10%−3%) = 12.1%. Key insight: Only systematic risk (beta) is rewarded — idiosyncratic risk can be diversified away. Uses: Estimating cost of equity for DCF, evaluating risk-adjusted performance (alpha), portfolio construction. Criticisms: Assumes investors hold the market portfolio, single-period model, beta is stable (empirically false). Despite flaws, CAPM remains the dominant framework for cost of equity.