The capital asset pricing model (CAPM) links an asset’s expected return to its exposure to market-wide risk. In equity valuation, it provides a model-implied required return, also called the cost of equity: the compensation shareholders would require under the model’s assumptions.
CAPM required return = risk-free rate + beta × expected equity market risk premium. The premium is the expected total market return minus the risk-free rate. Beta is a unitless measure of sensitivity to market returns; it is not the asset’s total volatility.
The model prices systematic risk: exposure to market-wide movements that remains in a diversified portfolio. Company-specific risk can be reduced through diversification, so CAPM does not assign it an additional expected-return premium. That does not make company-specific losses harmless.
Assume a one-year risk-free rate of 3%, beta of 1.2 and an expected market premium of 5 percentage points. CAPM gives 3% + 1.2 × 5% = 9% per year. The assumed total market return is 8%: 3% plus the 5-percentage-point premium. These are hypothetical inputs, not current market estimates.
Required return is a valuation discount-rate input. Expected return is an uncertain forward-looking average; CAPM equates it with required return in its equilibrium model. Realised return is what actually happened. The hypothetical 9% does not establish what an asset will earn.
The standard model assumes investors judge one-period portfolios by expected return and variance, share expectations, and can borrow or lend at a common risk-free rate in frictionless markets. Real markets differ. Estimated betas change with the sample and chosen index, and the theoretical market portfolio is broader than a stock index.
Fama and French document serious empirical failures of the relationship between beta and average returns. Read their 2004 paper, including the market-proxy discussion. The theoretical starting point is Sharpe’s 1964 model. CAPM is educational model arithmetic, not investment advice or evidence that a security is attractive.
No. The premium is the expected market return above the risk-free rate. With hypothetical inputs of 3% risk-free and a 5-percentage-point premium, the assumed total market return is 8%.
No. It is a model-implied expected return used as a required-return input in equity valuation. Realised returns can differ substantially, including losses.
Not directly. Cash flows to shareholders require a cost of equity; cash flows to all capital providers require a matching cost-of-capital framework, commonly WACC.
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Educational research only — not investment advice.