Question

Q. Explain the capital asset pricing model (CAPM), including the required assumptions, and the security market line (SML).?

Answer 1

The CAPM talks about the fact that return on a security depends only on the systematic risk. No matter wherever money is invested we cannot eliminate this risk. Unlike unsystematic risk, this risk cannot be reduced by diversification. Such systematic return is dependent upon market returns. It has the following assumptions:

• Risk-averse investors
• Absence of taxes or transaction costs
• All investors have homogenous(similar) expectations
• Because of risk-free interest rate, there is no limit to lending or borrowing
• Prices cannot be influenced by investors that is all of them are price takers

In CAPM, the measure for systematic risk is given by beta. It considers the total risk of a stock only comprises of systematic risk. Market risk is considered as unity that is 1.

SML that is Securities Market Line shows the expected return of a security if CAPM holds good. For a stock, SML gives the return as:

Stock return=Risk free return+(Market return-Risk free return)*Stock Beta

With the help of SML we compare our required return which helps to judge whether stock is under priced, overpriced or correctly priced.