Question

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

Answer 1

Answer:

CAPM model developed by William F. Sharpe and John Lintner, uses the beta of of the security , risk free rate and risk premium to calculate expected rate of return of security.

Risk premium represented by beta which is plotted in the graph and it yields a straight line and the slope of the a regression relationship which known as the Security Market Line(SML). It begins from expected rate of return and continues to grow with beta value. SML line reflects the expected return and beta relationship graphically. SML is upward sloping line from expected return.

SML is expressed as

E(R) = R_f + (E(R_m ) - R_f ) × beta

E(R) = expected rate of return

R_{f ^{= Risk free rate}}

R_m = Market rate of return

Example,

Risk free rate = 8%

beta = 1.25

Market rate of return = 14%

Fair return as per SML is

E(R) = 8 + 1.25 (14 - 8)

= 15.5%

O is overpriced security

P is underpriced security

Note: fair return is return stipulated by SML.