4.3c Capital Asset Pricing Model

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a financial framework built on top of Modern Portfolio Theory that links the expected return of an asset to its risk. It is based on a few key assumptions:

• All investors are rational and risk-averse.
• Only systematic risk matters, because idiosyncratic risk is diversified away.
• Markets are frictionless (i.e., no transaction costs, borrowing constraints, etc.)

CAPM is a single-factor model, which means it explains an asset’s expected return solely through its sensitivity to market risk through the factor, beta:
$\mathbb{E}(R_p)=R_f+{\beta }_p[\mathbb{E}(R_M)-R_f],$
where ${\beta }_p=\frac{{\sigma }_{p,M}}{{\sigma }_M}={\rho }_{p,M}\cdot \frac{{\sigma }_p}{{\sigma }_M}$ is a measure of the relative sensitivity of the portfolio to market movements.

This fundamental equation gives rise to the security market line, which measures the expected return of a portfolio against its beta.

CAPM for Assets vs. Porfolios

CAPM can be used for both quantifying individual assets and whole portfolios.