Applications of CAPM

Applications of CAPM

CAPM can be extended to a number of areas. It provides additional applications beyond the estimation of security returns. A key area is in performance evaluation, where a number of commonly used metrics are employed.

Performance Evaluation

Various computable performance metrics are extensions of CAPM. These metrics allow for the assessment of portfolio performance and evaluation. Active managers are expected to perform better than their passive counterparts or to, at least, cover the costs of active management. There are four ratios commonly used in performance evaluation. All measures assume that the benchmark market portfolio is the correct one, and if it is not, it may make results inaccurate. The benchmark should be appropriate for the portfolio being measured. Besides, it should exhibit similar characteristics. We shall see these performance measures in detail in the next LOS.

Security Selection

The CAPM assumes that investors have homogeneous expectations, are rational and risk-averse, and assign the same value to all assets to create the same risky market portfolio. If investors are heterogeneous, their different beliefs could result in a valuation or price for a security that is different from the CAPM-calculated price. The CAPM-calculated price is the current market price because it reflects the beliefs of all other investors in the market. An investor’s estimated price can sometimes be higher than the current market price. Such a circumstance should inform the investor’s decision to buy the asset because it is considered undervalued by the market.

A Jensen’s alpha for individual securities can also be computed with positive values. This indicates that the security is likely to outperform the market on a risk-adjusted basis.

A Security Market Line (SML) can present similar information on a graph. The expected return and beta for security can be assessed against the SML with undervalued securities relative to market consensus appearing above the SML. The securities overvalued relative to market consensus will appear below the SML.


Portfolio Construction

CAPM suggests that investors should hold a market portfolio and a risk-free asset. The true market portfolio consists of a large number of securities, and it may not be practical for an investor to own them all. Much of the non-systematic risk can be diversified by holding 30 or more individual securities. However, these securities should be randomly selected from multiple asset classes. An index may serve as the best method of creating diversification.

It is important to note that only non-systematic risk can be eliminated through the addition of different securities into the portfolio. Systematic risk – the risk inherent to the entire market – cannot be diversified.


Securities not included within the index can be evaluated relative to the index to determine their suitability for portfolio inclusion. The alpha and beta of the security can be estimated relative to the index, and those with a positive alpha should be included. The same exercise can be conducted for securities within the index – those with negative alphas relative to the index should be excluded or sold short.

To determine the weight of each security within a portfolio, those securities with higher alpha should be given more weight. Nonetheless, this weight should be proportional to the alpha divided by the security’s non-systematic variance (risk).

Limitations of CAPM

The CAPM is subject to theoretical and practical implications. From a theoretical perspective, it is both a single-factor and single-period model. There may be other factors over multi-time periods that would be more appropriate in modeling expected returns. Practically, the following are the limitations:

  • Market portfolio: The true market portfolio includes all assets, financial and non-financial, which may not be investable or tradeable.
  • Proxy for market portfolio: A proxy for the market portfolio is used, but different analysts tend to use different proxies.
  • Estimation of beta risk: A long history is required to estimate beta. However, the history may not be an accurate representation of the future beta. Indeed, different historical periods (3 years versus 5 years) and different data frequencies (daily versus monthly) are likely to produce different betas.
  • Poor returns prediction: The empirical support for CAPM is weak – the model is not good at predicting future returns. This, in turn, indicates that asset returns cannot be determined solely by systematic risk.
  • Homogeneity in investor expectations: In reality, investors are unlikely to have homogeneous expectations. There will be many optimal risky portfolios and numerous Security Market Lines (SMLs).


An overvalued security would most likely plot:

A. Below the Security Market Line (SML).

B. On the Security Market Line (SML).

C. Above the Security Market Line (SML).


The correct answer is A.

Securities overvalued, relative to market consensus, will appear below the SML. On the other hand, securities undervalued, relative to market consensus, will appear above the SML. Securities correctly priced will appear directly on the SML.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep

    Sergio Torrico
    Sergio Torrico
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.