CAPM (Capital Asset Pricing Model)
Quantitative Finance glossary · Quantitative Finance
Definition
Equilibrium model relating expected asset return to systematic market risk: E[R_i] = r_f + β_i,(E[R_m] - r_f), with β_i = (Cov(R_i, R_m))/(Var(R_m)). Derived from mean-variance preferences plus a tangency-portfolio market clearing. Empirically, the security market line is flatter than CAPM predicts (low-beta anomaly), motivating multi-factor extensions (Fama-French, Carhart). Used pragmatically as the cost-of-equity input to WACC despite being a poor unconditional return predictor.
CAPM (Capital Asset Pricing Model) in plain English
CAPM is a simple theory of what return you deserve for taking on risk. Its big idea: you don't get rewarded for a stock's random personal ups and downs (you could cancel those out by owning many stocks), only for how much it swings along with the whole market. That market-sensitivity is called beta — a beta of 2 means the stock tends to move about twice as hard as the market, up and down, so investors demand extra expected return to hold it, on top of the safe 'risk-free' rate you'd earn from something like a government bond. Think of it as a pay scale: the more of the market's unavoidable, can't-diversify-away risk you shoulder, the bigger the expected payoff. Real markets don't obey it perfectly, but it's still the standard back-of-envelope tool for estimating what a company's shareholders should expect to earn.
Related Quantitative Finance terms
Quantitative Finance practice questions · Quantitative Finance flashcards · Quantitative Finance study guide