Capital asset pricing model

How much return should an investor demand for taking on risk? The capital asset pricing model gives a clean, influential, and much-criticised answer.

The capital asset pricing model is a theory that estimates the return an investor should require from an asset, given its risk relative to the market as a whole. It provides a way to price risk, linking the expected return on an asset to a single measure of its market-related risk, and it underpins much of how the cost of equity is calculated.

Only systematic risk is rewarded

The model's key insight is that not all risk is rewarded. Risk specific to an individual asset can be diversified away by holding a varied portfolio, so investors should not expect compensation for it. Only systematic risk, the risk that cannot be diversified because it moves with the whole market, deserves a return. The model therefore prices an asset according to how much it contributes to the risk of a diversified portfolio, captured by its beta, a measure of how strongly its returns move with the market.

The risk-return relationship

The model expresses required return as the sum of the risk-free rate, the return on a safe asset, plus a premium for risk that depends on the asset's beta and the overall market risk premium. An asset that moves more than the market, with a high beta, must offer a higher return to compensate for amplifying market risk; one that moves less, with a low beta, can offer less. This gives a clean, linear relationship between systematic risk and required return, the security market line, that is intuitive and easy to apply.

Influence and criticism

The capital asset pricing model has been enormously influential, providing the standard method for estimating the cost of equity and a clear conceptual framework for thinking about risk and return. But it has been heavily criticised. Its assumptions, of efficient markets, rational investors, and a single measure of risk, are unrealistic, and empirical tests have found that beta alone explains returns poorly, prompting richer models with additional risk factors. Many practitioners use it while acknowledging it is, at best, a rough approximation.

The capital asset pricing model is a landmark of finance theory, the clean idea that only undiversifiable risk is rewarded and that an asset's required return rises with its sensitivity to the market. Its elegance and influence are matched by its empirical weaknesses, making it a model that is simultaneously a foundation of how risk is priced and a target of persistent criticism, used widely for want of anything both simple and clearly better.