Sharpe (1964) - Capital Asset Prices: A Theory of Market Equilibrium (CAPM)
Key Insights
- William Sharpe's CAPM provides the theory of how assets are priced in equilibrium, showing that expected return is linearly related to systematic risk measured by beta.
Edit on GitHub — registry.json
Overview
Sharpe (1964) — with Lintner (1965) and Mossin (1966) — develops the CAPM, providing the first complete theory of asset pricing in equilibrium. Expected return is linearly related to beta, the asset's sensitivity to the market portfolio, and beta is the only priced risk.
The Step Beyond Markowitz
Markowitz showed investors should hold mean-variance efficient portfolios. Sharpe asked the equilibrium question: if every investor optimizes this way, what must prices look like? With homogeneous expectations and the ability to lend and borrow at the risk-free rate, all investors hold the same risky portfolio — the market portfolio — combined with the risk-free asset. The capital market line describes this relationship, and the security market line extends it to every individual asset.
The Model
For any asset, expected excess return equals beta times the market risk premium, where beta is cov(asset, market) / var(market). The radical implication: only systematic risk — the component that correlates with the market — is priced. Idiosyncratic risk earns no compensation because it diversifies away. The model also yields the mutual fund theorem: the market portfolio is the only risky asset anyone needs, and portfolio construction reduces to choosing how much market risk to bear.
Why It Matters
CAPM gave finance its first usable cost-of-capital formula and its first risk decomposition. Its empirical failures — alpha and the size/value anomalies that later models were built to absorb — are as instructive as its successes. The model's intellectual structure (a single priced factor, a market portfolio, linear expected returns) is the template every later factor model, including Fama-French, extends.
Key Takeaways
- Beta is the only priced risk in equilibrium — diversification makes idiosyncratic risk uncompensated.
- Every investor holds the market portfolio; the security market line prices all assets from it.
- CAPM's failures defined the factor-model agenda: alpha was the anomaly that HML, SMB, RMW, and CMA were built to explain.