Question

What is the Capital Asset Pricing Model (CAPM) and how does the security market line illustrate how this model works?

Answer 1

Capital Asset pricing model is a model in order to estimate the expected rate of return and investor will be desiring out of investing into a particular asset or a particular stock portfolio so Capital Asset pricing model will be required in order to determine the rate of return which will be expected by the investor after ascertainment of factors like systematic risk which will be represented through beta and market risk premium which will be derived after deducting the risk free rate from the market rate of interest and we will also add the risk free rate in order to arrive at expected rate of return of a security or a particular stock portfolio.

Capital Asset pricing model is based upon various assumptions and they will be related to assumptions that all the portfolio are completely diversified and the risk is only reflected through one factor and it is a one factor model because the risk related to investment is only systematic risk and this will be reflected through beta.

Security market line is a line which will be representing the rate of return of the the various securities against systematic risk embedded with those securities. This line is also known as a risk return trade off.

Any securities which has been plotted above the security market line is considered overvalued and any other security which has been plotted below the security market line is considered as undervalued.