Lesson 2 of 6 · All lessons in this module
  1. Return-generating models, the market model and betaVideo lesson
  2. The CAPM: assumptions, the SML and its limitsVideo lesson
  3. Estimating beta for the cost of equity
  4. Industry betas: unlevering and relevering
  5. The market risk premium and the country risk premium
  6. APT and the four-factor model for the cost of equity

This lesson is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.

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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