Capital asset pricing model (CAPM)
Principles of Finance glossary · Risk, Return & Portfolio Theory
Definition
An equilibrium asset pricing model in which a security's expected return equals the risk-free rate plus its beta times the equity risk premium: r_e = r_f + β_e · (r_m - r_f). Prices systematic risk only - idiosyncratic risk is diversified away.
Capital asset pricing model (CAPM) in plain English
CAPM is a recipe for answering "what return should investors reasonably expect from a stock, given how risky it is?" It starts with the "risk-free rate" — what you'd earn on a super-safe investment like a government bond — and then adds a bonus for taking on risk. The key insight is that only ONE kind of risk earns you that bonus: risk you can't dodge by spreading your money across many stocks (called "systematic" risk), because the wobble unique to any single company ("idiosyncratic" risk) cancels out in a big mix and so the market won't pay you extra for it. A stock's "beta" (β_e) measures how much it amplifies the market's swings — a beta of 2 means it lurches twice as hard as the market — and you multiply that by the market's overall risk bonus to size the reward, giving r_e = r_f + β_e · (r_m - r_f).
Also called: CAPM
Practice Capital asset pricing model (CAPM)
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