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9.2 Capital Asset Pricing Model (CAPM)

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Series 65 Uniform Investment Adviser Law

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1 Introduction

About the Series 65 How to Use This Guide

2 Chapter 1: Economic Factors & Business Cycles

1.1 Business Cycles 1.2 Monetary Policy 1.3 Fiscal Policy 1.4 Inflation & Deflation 1.5 Interest Rates & Yield Curves 1.6 Global Economic Factors

3 Chapter 2: Financial Reporting & Analytical Methods

2.1 Financial Statements Overview 2.2 Accounting Fundamentals 2.3 SEC Filings & Annual Reports 2.4 Financial Ratios 2.5 Time Value of Money 2.6 IRR and NPV 2.7 Descriptive Statistics

4 Chapter 3: Types of Risk

3.1 Systematic (Market) Risk 3.2 Unsystematic (Company-Specific) Risk 3.3 Interest Rate & Reinvestment Risk 3.4 Inflation & Currency Risk 3.5 Liquidity Risk & Opportunity Cost 3.6 Risk Measurement & Portfolio Theory

5 Chapter 4: Cash Equivalents & Fixed Income Securities

4.1 Cash & Cash Equivalents 4.2 Treasury Securities 4.3 Agency Securities 4.4 Corporate Bonds 4.5 Municipal Bonds 4.6 Bond Pricing & Yields

6 Chapter 5: Equity Securities

5.1 Common Stock 5.2 Preferred Stock 5.3 Shareholder Rights & Corporate Actions 5.4 Equity Valuation Methods 5.5 ADRs, REITs & Other Equity Securities

7 Chapter 6: Pooled Investments

6.1 Mutual Funds 6.2 Mutual Fund Costs & Fees 6.3 Exchange-Traded Funds (ETFs) 6.4 Closed-End Funds & UITs 6.5 Hedge Funds & Private Equity

8 Chapter 7: Derivatives, Alternative Investments & Insurance Products

7.1 Options Basics 7.2 Options Strategies 7.3 Alternative Investments 7.4 Annuities 7.5 Life Insurance Products

9 Chapter 8: Client Types & Profiles

8.1 Individual Clients 8.2 Business Entity Clients 8.3 Trusts & Estates 8.4 Accredited & Qualified Investors 8.5 Suitability & Know Your Customer

10 Chapter 9: Portfolio Theory & Capital Markets

9.1 Modern Portfolio Theory 9.2 Capital Asset Pricing Model (CAPM) 9.3 Efficient Market Hypothesis 9.4 Risk & Performance Measures 9.5 Asset Allocation

11 Chapter 10: Portfolio Management Strategies

10.1 Investment Styles 10.2 Portfolio Management Techniques 10.3 Fixed Income Strategies 10.4 Return Calculations

12 Chapter 11: Tax Considerations & Retirement Planning

11.1 Capital Gains & Investment Taxes 11.2 Retirement Plans Overview 11.3 Individual Retirement Accounts (IRAs) 11.4 Education Savings Plans 11.5 Distributions & RMDs

13 Chapter 12: ERISA, Special Accounts & Performance Measures

12.1 ERISA Requirements 12.2 Special Account Types 12.3 Performance Measures & Reporting 12.4 QDROs & Special Situations

14 Chapter 13: Regulation of Investment Advisers

13.1 Investment Advisers Act of 1940 13.2 Registration Requirements 13.3 Recordkeeping Requirements 13.4 Custody Requirements 13.5 Exempt Reporting Advisers

15 Chapter 14: Regulation of Investment Adviser Representatives

14.1 IAR Definition & Requirements 14.2 Registration & Post-Registration 14.3 IARs of Federal Covered Advisers

16 Chapter 15: Regulation of Broker-Dealers & Agents

15.1 Broker-Dealer Definition 15.2 Agent Registration 15.3 Regulation Best Interest

17 Chapter 16: Securities Registration & Exemptions

16.1 Uniform Securities Act 16.2 Securities Registration Methods 16.3 Exempt Securities 16.4 Exempt Transactions

18 Chapter 17: Communications & Client Relationships

17.1 Advertising Rules 17.2 Social Media & Electronic Communications 17.3 Client Agreements & Disclosure 17.4 Proxy Voting & Other Obligations

19 Chapter 18: Ethics & Fiduciary Obligations

18.1 Fiduciary Duties 18.2 Prohibited Practices 18.3 Senior & Vulnerable Adult Protection 18.4 AML & Compliance Programs

9.2 Capital Asset Pricing Model (CAPM)

Key Takeaways Explain This Topic AI

Expected return equals risk-free rate plus beta times market premium.

Beta measures systematic risk relative to the market.

Beta below 1 is defensive; above 1 is aggressive.

Portfolio beta is a weighted average of component betas.

The SML plots expected return versus beta.

Securities above the SML are undervalued; below are overvalued.

Last updated: December 2025

The Capital Asset Pricing Model, developed by William Sharpe (building on Markowitz's work), describes the relationship between systematic risk and expected return. It is one of the most important concepts for the Series 65 exam.

The CAPM Formula E ( R ) = R f + β × ( R m − R f ) E(R) = R_f + \beta \times (R_m - R_f) E ( R ) = R f ​ + β × ( R m ​ − R f ​ )

Where:

  • E ( R ) E(R) E ( R ) = Expected Return
  • R f R_f R f ​ = Risk-Free Rate
  • β \beta β = Beta (systematic risk measure)
  • R m R_m R m ​ = Expected Market Return
  • ( R m − R f ) (R_m - R_f) ( R m ​ − R f ​ ) = Market Risk Premium
  • Formula Components
  • Component Symbol Description Typical Value
  • Expected Return E(R) Required return on the security Calculated
  • Risk-Free Rate Rf Return on risk-free investment 91-day T-bill rate
  • Beta β Measure of systematic risk Varies by security
  • Market Return Rm Expected return of the market Historical ~10%
  • Market Risk Premium Rm − Rf Extra return for market risk Historical 5-7%
  • Understanding Beta (β)

Beta is the cornerstone of CAPM . It measures a security's sensitivity to market movements—its systematic risk.

Beta Interpretation

  • Beta Value Interpretation Example Securities
  • β = 0 No market risk (risk-free) T-bills
  • β = 0.5 Half as volatile as market Utilities, consumer staples
  • β = 1.0 Same volatility as market S&P 500 index fund
  • β = 1.5 50% more volatile than market Technology stocks
  • β = 2.0 Twice as volatile as market High-growth/speculative stocks
  • β < 0 Moves opposite to market Gold (sometimes), inverse ETFs
  • Beta Categories
  • Category Beta Range Characteristics
  • Defensive β < 1.0 Less volatile; falls less in down markets, rises less in up markets
  • Neutral β = 1.0 Moves with the market
  • Aggressive β > 1.0 More volatile; amplifies market movements
  • Calculating Portfolio Beta

Portfolio beta is the weighted average of individual security betas: β p = ∑ i = 1 n ( w i × β i ) \beta_p = \sum_{i=1}^{n} (w_i \times \beta_i) β p ​ = i = 1 ∑ n ​ ( w i ​ × β i ​ )

Example : Portfolio with:

  • 60% Stock A ( β = 1.2 \beta = 1.2 β = 1.2 )
  • 40% Stock B ( β = 0.8 \beta = 0.8 β = 0.8 )

β p = ( 0.60 × 1.2 ) + ( 0.40 × 0.8 ) = 0.72 + 0.32 = \beta_p = (0.60 \times 1.2) + (0.40 \times 0.8) = 0.72 + 0.32 = β p ​ = ( 0.60 × 1.2 ) + ( 0.40 × 0.8 ) = 0.72 + 0.32 = 1.04

  • CAPM Calculation Examples
  • Example 1: Basic Calculation

Given:

  • Risk-free rate ( R f R_f R f ​ ) = 3%
  • Expected market return ( R m R_m R m ​ ) = 11%
  • Stock's beta ( β \beta β ) = 1.5

Calculate expected return: E ( R ) = 3 % + 1.5 × ( 11 % − 3 % ) E(R) = 3\% + 1.5 \times (11\% - 3\%) E ( R ) = 3% + 1.5 × ( 11% − 3% ) E ( R ) = 3 % + 1.5 × 8 % E(R) = 3\% + 1.5 \times 8\% E ( R ) = 3% + 1.5 × 8% E ( R ) = 3 % + 12 % = 15 % E(R) = 3\% + 12\% = \mathbf{15\%} E ( R ) = 3% + 12% = 15%

Example 2: Finding Beta

Given:

  • Expected return = 14%
  • Risk-free rate = 2%
  • Market return = 10%

Calculate beta: 14 % = 2 % + β × ( 10 % − 2 % ) 14\% = 2\% + \beta \times (10\% - 2\%) 14% = 2% + β × ( 10% − 2% ) 12 % = β × 8 % 12\% = \beta \times 8\% 12% = β × 8% β = 12 % 8 % = 1.5 \beta = \frac{12\%}{8\%} = \mathbf{1.5} β = 8% 12% ​ = 1.5

The Security Market Line (SML)

The SML is the graphical representation of CAPM .

SML Characteristics

  • Feature Description
  • X-axis Beta (systematic risk)
  • Y-axis Expected return
  • Y-intercept Risk-free rate
  • Slope Market risk premium (Rm − Rf)
  • Security Positioning on SML
  • Position Meaning Investment Decision
  • On the SML Fairly priced Hold
  • Above the SML Undervalued (return > required) Buy
  • Below the SML Overvalued (return < required) Sell
  • SML vs. CML: Key Differences
  • Feature Security Market Line (SML) Capital Market Line (CML)
  • Risk Measure Beta (systematic risk) Standard deviation (total risk)
  • What it plots Individual securities and portfolios Only efficient portfolios
  • Derived from CAPM Efficient frontier + risk-free asset
  • Slope Market risk premium Market Sharpe ratio
  • CAPM Assumptions and Limitations
  • Assumptions
  • Investors are rational and risk-averse
  • All investors have the same expectations
  • Investors can borrow/lend at the risk-free rate
  • No taxes or transaction costs
  • Single-period investment horizon
  • Limitations
  • Beta may not be stable over time
  • Historical beta may not predict future beta
  • Single-factor model (ignores other risk factors)
  • Assumes returns are normally distributed
  • Real-world frictions (taxes, costs) exist
  • In Practice

Investment professionals use CAPM to:

  • Determine required returns for stocks
  • Evaluate whether securities are over/undervalued
  • Calculate cost of equity for corporate finance decisions
  • Set return expectations based on risk
  • On the Exam

Series 65 frequently tests:

  • CAPM calculations (expect to calculate expected return given beta, Rf, and Rm)
  • Beta interpretation (defensive vs. aggressive)
  • SML position and investment decisions
  • Difference between SML (uses beta) and CML (uses standard deviation)
  • Key Takeaways
  • CAPM: E ( R ) = R f + β ( R m − R f ) E(R) = R_f + \beta(R_m - R_f) E ( R ) = R f ​ + β ( R m ​ − R f ​ )
  • Beta measures systematic risk relative to the market
  • β < 1 \beta < 1 β < 1 = defensive; β > 1 \beta > 1 β > 1 = aggressive; β = 1 \beta = 1 β = 1 = market
  • Portfolio beta = weighted average of security betas
  • SML plots expected return vs. beta
  • Securities above SML are undervalued; below SML are overvalued

Loading diagram... CAPM Inputs