Question

What is the capital asset pricing model (CAPM)? What is its relation to the security market line (SML)?

Answer 1

The capital asset pricing model describes the relationship between the systematic risk of a security and its expected return. The security market uses the calculated results from the CAPM formula and determines if an investment in a security or portfolio are reasonable.

The Capital Asset Pricing Model calculates the expected return on equity of an individual company. It is based on the expected rate of return on the market, the risk-free rate and the beta coefficient of an individual security or portfolio.

CAPM = risk free rate + beta ( market risk premium)

The Security Market Line is essentially a graph representation of CAPM formula. It plots the expected return of stocks on the y-axis, against beta on the x-axis. The intercept is the risk free rate and the slope represents the market premium. Individual securities’ expected return and risk are plotted on the SML graph. For one security, if it is plotted above the SML, it is undervalued as the investors are expecting a greater return for the same amount of risk (beta). If it is plotted below the SML, it is overvalued as the investors would accept a lower return for the same amount of risk (beta)