CAPM and the Fama-French Model: How Finance Prices Risk

Finance has one central idea: higher expected return is compensation for higher risk. The models below make that precise.

CAPM: risk in one number

The Capital Asset Pricing Model says an asset's expected return equals the risk-free rate plus its beta (how much it moves with the market) times the market risk premium. Beta captures the only risk CAPM thinks you get paid for: risk you cannot diversify away.

Fama-French: beta is not enough

Eugene Fama and Kenneth French showed that CAPM's single factor misses real patterns. Their three-factor model adds two more: size (small companies have historically out-returned large ones) and value (cheap “value” stocks have out-returned expensive “growth” ones). Later versions add profitability and investment factors.

Why it matters

These models set the cost of equity — the return investors demand — which feeds directly into valuation and every major capital decision. Pair them with the real options view of flexible investments. Browse the Finance library for more.