A method of valuing assets and calculating the cost of capital (for an alternative, see arbitrage pricing theory). The capital asset pricing model (CAPM) has come to dominate modern finance. The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of risk, known as residual risk or alpha, by holding a diversified portfolio of assets (see modern portfolio theory). These alpha risks are specific to an individual asset, for example, the risk that a company’s managers will turn out to be no good. Some risks, such as that of a global recession, cannot be eliminated through diversification. So even a basket of all of the shares in a stock market will still be risky. People must be rewarded for investing in such a risky basket by earning returns on average above those that they can get on safer assets, such as treasury bills. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset’s price is affected by the risk of the market as a whole. The market’s risk contribution is captured by a measure of relative volatility, beta, which ¬indicates how much an asset’s price is expected to change when the overall market changes. Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk-free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset’s beta. But does the CAPM work? It all comes down to beta, which some economists have found of dubious use. They think the CAPM may be an elegant theory that is no good in practice. Yet it is probably the best and certainly the most widely used method for calculating the cost of capital.