Overview

Every discounted-cash-flow valuation, every cost-of-capital calculation, every hurdle rate set in corporate finance depends on one number: the expected return on equity. That number comes from an equilibrium model. The dominant model for the last 60 years — used by textbooks, regulators, and practitioners from equity analysts to infrastructure project teams — is the Capital Asset Pricing Model (CAPM). Its central claim is a single equation:

Every stock's expected excess return equals its beta times the market risk premium. Idiosyncratic risk earns nothing — because diversification is free and any investor who holds the market portfolio has already eliminated it. Beta, the sensitivity of a stock's return to the market, is the only relevant risk measure.

This topic tracks the full arc of this theory:

1. International diversification — broadening the investment opportunity set across currencies and markets as a pre-cursor to thinking globally about the market portfolio.
2. The Capital Market Line and Separation Theorem — the role of the riskless asset in collapsing the efficient frontier to a single ray; two-fund separation.
3. CAPM and the Security Market Line — deriving the SML and showing that beta is the only priced risk factor.
4. Derivation — CAPM from Portfolio Theory — the rigorous mathematical derivation from Lagrangian optimality conditions.
5. Non-standard CAPM forms — relaxing the standard assumptions: zero-beta CAPM (no riskless asset), taxation, heterogeneous expectations, multi-beta CAPMs.
6. Empirical tests and Roll's Critique — the Fama-MacBeth methodology, the empirical failure to find a clean beta-return relationship, and Roll's (1977) devastating critique that the CAPM is impossible to test.
7. Arbitrage Pricing Theory — Ross's alternative: no-arbitrage pricing under a multi-factor structure, without requiring the market portfolio or homogeneous expectations.

1. Learning objectives
2. Contents
3. The big picture