November 11, 2025
11 mins read
The Capital Asset Pricing Model, Or CAPM, is one of those tools in finance that tries to tie risk and return together in a single neat equation. On paper, it looks simple: systematic risk versus expected return. But when you unpack it, the CAPM Model is about more than just math.
What CAPM Model really does is explain how much return an investor should demand for taking on a particular level of risk. It connects volatility, the risk-free rate, and the market’s own risk premium. In short, it’s a framework to check if a security is priced fairly, given its risk.
Investors use CAPM Model not just for valuing assets but also for deciding if their portfolios are aligned with expected returns. Capital Asset Pricing Model is a benchmark, a guide — but not a flawless one.
The CAPM Model formula is written as:
Ei = Rrf + βi × (Em – Rrf)
Where:
Ei = Expected return on the investment
Rrf = Risk-free rate of return
βi (beta) = Volatility of the asset relative to the market
Em = Expected return from the market
So, what does this mean? The formula starts with a baseline — the risk-free rate. To this, it adds a premium for risk, adjusted by beta. Beta indicates how sensitive a security is to the swings of the market. If you multiply beta by the market risk premium (Em – Rrf), you will have the amount of excess return that an investor would expect as compensation for taking on that risk.
A stock is valued at ₹120 and will pay an annual dividend of 4%. Its beta is 1.25, which means it is 25% more volatile than the NIFTY 50. The risk-free rate is 4%, and the market is estimated to provide a return of 12%.
Calculation:
Ei = 4 + 1.25 × (12 – 4)
Ei = 4 + 10
Ei = the expected return of 14%.
If the future cash flows discounted at this 14% equal ₹120, then the stock is fairly priced.
Assuming another NIFTY 50 stock with a beta of 1.10, and the 10-year G-sec yield is 6.4%, while we expect the market return to be 12.5%.
Calculation:
Ei = 6.4 + 1.10 × (12.5 – 6.4)
Ei = 6.4 + 6.71
Ei = the expected return of 13.11%.
Once again, if future cash flows discounted at 13.11% equal the current stock price, then the stock is fairly valued under the CAPM Model.
Now that you know what CAPM is and what its uses are, there are important caveats that you need to know.
The CAPM Model assumes that the equity markets are generally efficient. In reality, there are mis-pricings because of information asymmetries and behavioural biases.
CAPM Model assumes that investors are rational and risk averse. Reality often proves otherwise.
Beta issues – Over long durations, beta doesn’t always capture performance. In shorter periods, the neat linear link between beta and return often breaks down.
Risk-free rate – CAPM Model assumes it stays constant, usually pegged to government bond yields. But bond yields fluctuate, making the “risk-free” anchor less reliable.
For an investor to utilize the CAPM model to manage his investments relative to risk, he would have to refer to a curve known as the “Efficient Frontier.” As per the figure, the expected return increases with the expected risk. Any asset or a portfolio starts at an expected return more than zero on the Y-axis because there is always the case of risk-free returns. Theoretically, the Capital Market Line (CML) represents better returns for a portfolio than any portfolio to its right. An investor needs to go beyond this line and understand the returns relative to risk taken. CML and Efficient Frontier, though cannot be defined conceptually, highlight an important takeaway for investors: more the risk incurred, more the returns. So, there is always a tradeoff between rewards and risk.
As shown above, portfolio 1 has an expected return of 12% for a risk level of 10%, whereas portfolio 2 has an expected return of 15% for a risk level of 20%. The returns for portfolio 2 does not increase commensurate with the risk taken and therefore, portfolio 1 is a better investment option than portfolio 2.
The assumptions of the CML are the same as of CAPM and it only exists theoretically. Also, any portfolio that lies on the efficient frontier will provide maximum returns for the risk taken. Since future returns cannot be accurately estimated, it is not possible to determine if a portfolio is on the line of efficient frontier. In order to manage these limitations, a modified version of the CML is more practically suited for investors which is known as the Security Market Line (SML).
The risk and return tradeoff that applies to CAPM also applies to the SML. In the SML, β is used instead of the risk. As the portfolio or the asset β increases, the return also increases. The SML and the CAPM theories establish a relationship between the returns and the β.
CAPM is used widely in performance assessment, pricing of securities, capital budgeting, and risk management. Some of the important application of CAPM are mentioned below -
Various metrics used for performance evaluations are derived from the CAPM concept. Such metrics are used to evaluate the performance of portfolios. Managers of active fund portfolios are expected to exceed the market performance and there are different ratios to track portfolio performance.
After the estimated returns are calculated by CAPM, if the future discounted cash flows of the security is equal to the current price of the security, then the security is fairly valued relative to the risk. Using the SML, the undervalued security will be to the left of the SML, whereas a fairly valued security will be on the SML. An overvalued security will be to the right of the SML. This information aids in the decision-making to add or shelve off securities from a portfolio.
A market portfolio may consist of a large number of securities and it may not be feasible for an investor to go through all of them and compute their valuations relative to risks. An index may serve as an indicator to which securities should be bought or sold.
For all its applications, there are several assumption underlying the CAPM model such as -
The CAPM model assumes that investors require returns only for the systematic portion of their risk because the unsystematic portion has already been taken care of by portfolio diversification and therefore need not be accounted for. In a way, the CAPM model considers all investors to be rational and risk-averse in behavior. Practically, it is possible for investors to diversify their portfolios but the level of diversification varies across investors. An investor who has invested across 10 securities has less diversification than the one with 100 securities. In the case of the former, the unsystematic risk cannot be ignored.
The holding period in the CAPM model is considered to be standardized and a holding period of one year is generally used. However, returns for a 1-year holding period cannot be compared with that for a 5-year holding period. Also, investors hold securities for more than a year in many cases.
The CAPM model assumes no transaction charges for borrowing and lending so there is always a minimum return at the risk-free rate. But in the real world, investors cannot borrow and lend at risk-free rates because transaction charges and a risk premium are added to the interest rates for debt.
CAPM assumes perfect capital markets, therefore, there is no information asymmetry along with taxes. So, all investors want to maximize their gains using the same information in a risk-averse manner. However, the reality is markets are not perfect and information asymmetry always exists.
Because of the simplistic assumptions of the CAPM model, other alternative models establishing the connection between risks and returns have been developed of which the Arbitrage Pricing Theory (APT) and Fama-French 3-factor model are the important ones.
The APT is generally used in value investing style and it proposes that the returns can be estimated through a linear relationship between expected returns and different macroeconomic variables. Developed in 1976 by Stephen Ross, an economist, the APT considers that markets are imperfect and sometimes misprice assets before correcting so that the asset value reverts to the fair value. APT considers inflation, gross national product, changes in yield curve, and spreads in bonds as macroeconomic factors affecting an asset’s returns.
Developed in 1992, the Fama-French 3-factor model considers value risk factors and size risk to systematic risks in CAPM. The three factors used in this model are firm size, book-to-market value, and excess returns on the market. Fama and French, the brains behind this model, added two more factors in 2014 to the existing three. Those two factors are profitability and investment.
Provides Assistance in security pricing – CAPM Model allows investors to determine if a security is under or over-valued. Capital Asset Pricing Model connects expected returns with systematic risk or beta. It serves as a benchmark for investors to make decisions.
Contributes to portfolio planning – Investors can assess how much risk they have in their portfolio relative to their expected return and use this information to help formulate the proper portfolio to their risk comfort level.
Clarifies risk premium – The Capital Asset Pricing Model provides a metric for the excess return that an investor would require to justify taking market risk. It allows for additional clarity on whether compensation is sufficient for the risk exposure.
Useful in corporate finance – Firms use CAPM Model to calculate cost of equity. This becomes essential in capital budgeting decisions and in assessing project feasibility.
Beta Value | Meaning | Impact on Returns |
β > 1 | Asset is more volatile than the market | Higher risk, higher expected return |
β < 1 | Asset is less volatile than the market | Lower risk, lower expected return |
β = 1 | Asset moves in line with the market | Return mirrors overall market return |
Negative β | Asset moves opposite to the market | Provides diversification benefit |
CAPM Model has shaped modern finance by putting risk and return in the same sentence. Capital Asset Pricing Model is not perfect as markets aren’t always efficient, and investor behaviour doesn’t follow neat equations but it gives a starting point.
For investors, CAPM is more of an indicator than a gospel truth. It helps frame expectations, compare securities, and think critically about whether risk is fairly rewarded. Pair it with other tools, and the Capital Asset Pricing Model becomes a valuable part of the toolkit.
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The key assumptions of CAPM are perfect markets, rational investors, absence of unsystematic risk due to diversification, and a standard holding period.
The CAPM adds the risk-free rate to the product of asset risk and market risk premium in order to arrive at expected returns for an asset or a portfolio.
CAPM does not consider that markets could be imperfect. Neither does it consider the fact that unsystematic risk could be present.
Some of the limitations of CAPM have been adjusted for in other asset pricing models developed later after CAPM.
No, the CAPM model typically applies only to securities within the equity market, not to other asset classes or investments.
Beta measures how much an asset’s risk and returns move in relation to overall market movements, indicating its relative volatility.
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