by Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin in the early 1960s was an important milestone in the development of modern portfolio theory. It is a simple mathematical model, and it is, like all scientific models, an attempt to capture some aspects of the world around us. But more than being a model, we view the CAPM as a framework for thinking about investments.1 The CAPM asks what happens, in the simplest possible world, when markets are efficient, all investors have identical information, and investors maximize the expected return in their portfolios and minimize the volatility. The CAPM is in this sense an equilibrium model. It takes market capitalizations as given and asks what must the levels of expected returns be for all investors to be satisfied holding the outstanding asset weights. The results provide a useful intuition about the long-run expected returns of different assets. The CAPM doesn't tell us what is the right level for the stock market at a point in time, but it does, for example, provide a basis for thinking about issues such as how much return should an investment in equity provide, how should the returns of different stocks differ as a function of their different risk characteristics, and how much equity belongs in a portfolio. In this chapter we develop the intuition behind the CAPM in a very simple setting. For now we will not investigate deviations from equilibrium. We are not interested in this chapter in modeling the real world or in dealing with realistic portfolios. Rather, we want to develop some intuition, especially about how expected returns must adjust when the world is populated with investors who are attempting to maximize return and to minimize risk. The next two chapters will focus on how to calibrate the premium associated with the equilibrium market portfolio; we will develop a global version of the model and try to calibrate it to more realistic aspects of the world so that we can apply it in practice. In Chapter 7, we will investigate how to use the equilibrium model in a more realistic context in which we have views about how the markets deviate from equilibrium. ]For a recent review with extensive references to the literature on the CAPM, see William Sharpe's 1990 Nobel Lecture: "Capital Asset Prices with and without Negative Holding," Nobel Lectures, Economic Sciences 1981-1990, 312-332.