Capital Asset Pricing Model (CAPM)

CAPM, developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, was one of the most influential models in finance despite its known simplifying assumptions. The model stated that the expected return of any asset was equal to the risk-free rate plus the asset's beta multiplied by the equity risk premium (the excess return of the market over the risk-free rate). Beta measured how sensitively the asset moved relative to the overall market: a beta of 1.0 meant the asset moved in line with the market, above 1.0 meant amplified moves, and below 1.0 meant dampened moves.

In Indian equity markets, CAPM was applied using the 10-year Government of India bond yield as the risk-free rate, the historical or expected Nifty 50 return minus this yield as the equity risk premium, and individual stock betas calculated against the Nifty. A stock with a beta of 1.5 trading on NSE would, under CAPM, be expected to deliver 1.5 times the equity risk premium above the risk-free rate. If the risk-free rate was 7 percent and the equity risk premium was 6 percent, the expected return would be 7% + 1.5 × 6% = 16%. If the stock's actual expected return was higher, it would plot above the Security Market Line (SML), suggesting it was undervalued relative to its risk; if lower, it suggested overvaluation.

The security market line — the graphical representation of CAPM — provided a benchmark for evaluating whether a security offered adequate compensation for its systematic risk. Alpha, in CAPM's framework, was the excess return above the SML prediction: positive alpha indicated value added beyond what the market risk explained, while negative alpha indicated underperformance relative to the risk taken. Portfolio managers in India's PMS and AIF industry were evaluated partly on the alpha they generated relative to their benchmark and risk level, making CAPM a practical performance attribution tool.

CAPM's assumptions — including a single-period investment horizon, no transaction costs, homogeneous expectations among investors, and the market portfolio being mean-variance efficient — were widely criticised as unrealistic. Empirical tests showed that other factors beyond beta, such as company size (small-cap premium), valuation (value premium), profitability, and momentum, explained cross-sectional return differences that CAPM could not account for. This gave rise to multi-factor models like the Fama-French three-factor and five-factor models, which extended CAPM by incorporating additional risk factors systematically.

Despite theoretical criticisms, CAPM remained the dominant tool for estimating cost of equity in corporate finance, valuation analysis, and regulatory determinations of fair return in infrastructure and utility sectors in India. SEBI's framework for evaluating PMS and AIF performance included risk-adjusted return metrics derived from CAPM principles, underscoring its continued relevance in Indian financial practice.