The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models | Free CFA Level I Lesson

A portfolio manager needs a required return for a single stock to discount its cash flows. Three workhorse models compete: CAPM (one factor, theoretical), the market model (one factor, empirical), and multi-factor models (APT and its descendants). Knowing which tool answers which question is the exam's core test.

CAPM says one thing: in equilibrium, an asset's expected return equals the risk-free rate plus a premium for the systematic (non-diversifiable) risk it adds to a fully diversified portfolio. That risk is measured by beta.

$E (R_{i}) = R_{f} + β_{i} [E (R_{m}) - R_{f}]$

Beta is a scaling factor on the market risk premium. $β_{i}$ = covariance of asset $i$ with the market, divided by the variance of the market:

$β_{i} = \frac{Cov ( R _{i} , R _{m} )}{Var ( R _{m} )}$

KEY: CAPM prices only systematic risk. Idiosyncratic risk (a CEO scandal, a factory fire) is diversified away in a market portfolio and earns no premium.

CAPM assumptions (testable in their own right): investors are risk-averse and rational, markets are frictionless (no taxes, no transaction costs), all investors share the same expectations and one-period horizon, all...

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Common mistakes

Confusing CAPM with the market model. CAPM is an equilibrium theory predicting expected returns with no alpha. The market model is an empirical regression of realized returns with a free alpha intercept. Trap: writing $R_{i} = α + β R_{m} + ϵ$ as if it were CAPM.
Multiplying beta by the market return instead of the premium. CAPM scales the equity risk premium $E (R_{m}) - R_{f}$ , not the whole market return. Trap: computing $R_{f} + β E (R_{m})$ instead of $R_{f} + β [E (R_{m}) - R_{f}]$ , which overstates the required return by $β R_{f}$ .
Treating APT as specifying particular factors. APT is a framework, not a list. The theory does not name inflation, GDP, or size as the factors. The analyst chooses. Trap: "APT requires the market, size, and value factors."

Bottom line

CAPM: $E (R_{i}) = R_{f} + β_{i} [E (R_{m}) - R_{f}]$ . Equilibrium, one factor (market risk), assumes diversified investors, prices only systematic risk.
Market model: $R_{i} = α_{i} + β_{i} R_{m} + ϵ_{i}$ . Empirical regression used to estimate beta and decompose returns, not a pricing theory, so it carries a free alpha.
APT: multi-factor, no-arbitrage. The theory does not specify the factors, the analyst chooses them empirically (macro or fundamental).
Fama-French-Carhart: market, size (SMB), value (HML), momentum (WML). Four factors explain the cross-section of returns better than CAPM alone.

Exam shortcut

For CAPM vs. market model: "CAPM forecasts (no alpha); market model fits (with alpha)." For APT, remember the theory gives you the equation but never the factors, the analyst picks. For Carhart, memorize MSV-M: Market, Size, Value, Momentum. The exam loves to plant negative loadings (especially momentum) to catch sign errors, double-check direction before summing.

The full lesson (about 2,354 words, 16 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.

Learning objectives

CAPM market model and factor models

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