CAPM (Capital Asset Pricing Model)
Definition
The Capital Asset Pricing Model estimates the required return on a stock as: expected return = risk-free rate + beta x equity risk premium, where the equity risk premium is the expected market return minus the risk-free rate. It is the standard tool for estimating the cost of equity.
The logic: investors can diversify away company-specific risk, so they are compensated only for systematic (market) risk, measured by beta. The risk-free rate is typically proxied by a long-term government bond yield (commonly the 10-year Treasury in the US) to match the long duration of equity cash flows.
CAPM's empirical record is imperfect (beta explains returns weakly; hence size, value, and other factor extensions), but it remains the interview and practitioner default because it is simple, transparent, and grounded in diversification theory.
Why interviewers ask
CAPM is the answer to "how do you calculate the cost of equity?" — you must state the formula exactly and define each input. Traps: writing the ERP as the market return instead of the market return minus the risk-free rate (double-counting the risk-free rate), and being unable to explain intuitively why only systematic risk is priced.
Related terms
Interviews don't test definitions — they test recall under pressure.
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