CAPM: Estimating Expected Returns from Systematic Risk

Summary

The article introduces the Capital Asset Pricing Model as a way to estimate an asset’s expected return from the risk-free rate, the asset’s beta, and the market risk premium. It distinguishes systematic risk, which affects the broader market, from unsystematic risk tied to individual firms, and explains that diversification can reduce the latter. A numerical example illustrates applying the formula to an asset with a stated beta and market assumptions. The article connects the estimate to portfolio selection and to a company’s cost of equity.

It outlines assumptions including diversified investors, a common holding period, borrowing and lending at a risk-free rate, and frictionless markets with available information. These simplifications limit how directly CAPM maps to actual markets. The article also surveys alternative asset-pricing approaches, including multi-factor models, as extensions that incorporate additional sources of return variation. Its worked examples explain mechanics rather than demonstrate predictive accuracy; the model’s estimates depend on inputs and assumptions, and the article notes that other models may improve on CAPM.

Key ideas

• CAPM estimates expected return as the risk-free rate plus beta multiplied by the market risk premium.
• Beta represents an asset’s sensitivity to systematic market risk.
• Diversification can reduce company-specific risk, while broad market risk remains.
• CAPM relies on assumptions such as diversified portfolios, a common investment horizon, and frictionless markets.
• The model can inform investment comparisons and cost-of-equity estimates.
• Multi-factor models add other return drivers, while CAPM estimates remain limited by their assumptions and inputs.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.