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What is the relationship between the risk and expected return of an investment? The capital asset pricing model (CAPM) provides an initial framework for answering this question. The CAPM (Sharpe, 1964; Lintner, 1965) marks the birth of asset pricing theory. This model is based on the idea that not all risk should affect asset prices. The model thus provides insight into the kind of risk that is related to return. Four decades later, the CAPM is still widely used in applications. The CAPM provides a methodology for translating risk into estimates of expected ROE. Its application continues to generate debate: many scholars argued that the CAPM is based on unrealistic assumptions. This paper lays out the key ideas of the CAPM, the history of empirical work on the CAPM and the implications of this work on the shortcomings of the CAPM.
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