Capital Asset Pricing Model (CAPM)

Overview

CAPM (Sharpe, 1964; Lintner, 1965) establishes a linear relationship between systematic risk and expected return. The model states that the expected return on any asset equals the risk-free rate plus a premium for bearing market risk, scaled by the asset's beta.

When to Use

• Estimating required rate of return for equity valuation
• Calculating cost of equity in WACC
• Comparing asset risk via beta
• Evaluating portfolio performance against the Security Market Line (SML)

When NOT to Use

• When the asset has significant exposure to size, value, or other factors beyond market risk
• For illiquid or non-traded assets where beta estimation is unreliable
• When market portfolio proxy is questionable (Roll's critique)