CAPM & Factor Models

CAPM prices assets off a single factor: market beta, the slope of the security market line, which says only undiversifiable systematic risk earns a premium because idiosyncratic risk can be diversified away for free. The theory is clean but empirically weak, since one beta explains average returns poorly, and anomalies such as size and value motivated APT-style multi-factor models, where expected return is factor exposures times factor premia. The Fama–French three- and five-factor models and commercial systems like Barra became the practical successors. For the optimizer, factor structure is also the cure for noisy covariance: a low-rank factor plus specific-variance form is more stable than a raw sample matrix.