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Lesson 2 of 6 · 15 min

The CAPM: assumptions, the SML and its limits

The CAPM says expected return depends only on beta: E(Ri)=Rf+βi[E(Rm)−Rf]E(R_i) = R_f + \beta_i[E(R_m) - R_f], drawn as the security market line, which prices every asset and portfolio.

In short

  • CAPM: E(Ri)=Rf+βi[E(Rm)−Rf]E(R_i) = R_f + \beta_i[E(R_m) - R_f]. Two assets with the same beta have the same expected return.
  • Six assumptions: risk-averse rational utility-maximisers; frictionless markets; one holding period; homogeneous expectations; infinitely divisible assets; price takers.
  • The security market line (SML) plots expected return against beta: intercept RfR_f, slope = market risk premium, passing through (1, E(Rm)E(R_m)).
  • The SML applies to any asset or portfolio, efficient or not; the CML uses total risk and applies only to efficient portfolios.
  • Portfolio beta is the weighted average of the holdings' betas. A negative-beta asset has an expected return below RfR_f.
  • Limitations: single factor, single period, unobservable market portfolio, proxy choice, unstable beta estimates, weak empirical fit, homogeneity. Extensions: APT and the four-factor model.

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The CAPM: assumptions, the SML and its limits · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models