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CFA® Level I · Equities · free lesson
The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models
Every present value model needs a required return on equity, and every portfolio manager needs to know which risks drive a stock's returns. This module shows how analysts use the CAPM to set the required return, how the market model is used to estimate beta and isolate company-specific returns, and how arbitrage pricing theory and multifactor models such as size, value and momentum extend the single-factor view.
What you will learn
1. Use the capital asset pricing model to estimate a company's required return on equity, and explain the choices involved in selecting its inputs.
- CAPM: required return = risk-free rate + beta x equity risk premium.
- Match the risk-free rate to the currency and horizon of the cash flows.
- The ERP can be historical, forward-looking or survey-based; the choice matters.
- Adjusted beta = 2/3 x raw beta + 1/3 x 1.0 reflects betas' drift toward 1.
- Expected return above the SML (positive alpha) suggests undervaluation.
2. Explain how the market model is used to estimate beta and to separate systematic from company-specific returns and risk.
- Market model: R_i = alpha + beta x R_m + error, estimated by regression.
- Beta = Cov(R_i, R_m) / Var(R_m) = correlation x sigma_i / sigma_m.
- The market model supplies the beta; the CAPM turns it into a required return.
- Total variance = beta^2 x market variance + residual variance; only systematic risk is priced.
- Abnormal return = actual return - (alpha + beta x market return), used in event studies.
3. Describe arbitrage pricing theory and multifactor models, calculate expected returns from factor exposures, and explain why multifactor models matter in equity investing.
- APT: expected return = Rf + sum of factor betas x factor risk premiums.
- APT relies on no-arbitrage and diversification but does not specify the factors.
- Factor models are macroeconomic, fundamental (size, value, momentum, quality) or statistical.
- Fama-French: market, SMB (size) and HML (value); a negative HML loading indicates a growth tilt.
- Uses: required returns, risk models, attribution, uncovering unintended bets and smart beta.
Module at a glance
- CAPM: r = Rf + beta x (E(Rm) - Rf); choose a risk-free rate matching the cash flows' currency and horizon.
- ERP estimates (historical, forward-looking, survey) differ; adjusted beta = 2/3 raw + 1/3.
- Expected return above the SML means positive alpha and apparent undervaluation.
- Market model regression gives beta = correlation x sigma_i / sigma_m.
- Total variance = systematic + unsystematic; only systematic risk is priced.
- Abnormal return = actual - (alpha + beta x market return).
- APT and multifactor models (size, value, momentum, quality) explain returns, reveal factor bets and separate skill from tilts.
This free module has 3 lessons, 11 practice questions with full explanations.