Question

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

Answer 1

CAPM is an economic model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. CAPM says

The general idea behind CAPM is that investors need to be compensated in two ways – the time value of money and risk

• Time value of money: The time value of money is represented by the risk-free rate in the formula and compensates the investors for placing money in any investment over a period of time.
• Risk: The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking β that compares the returns of the asset to the market over a period of time and to the market premium E(Rm) – Rf.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.

While there is nothing risk free, any security backed by the government (Treasury bills, notes, bonds) is considered to be risk free. Government securities are considered to be risk free because a government is never expected to default. If it runs out of money or is on the verge of default, it can always print money or increase the level of direct and / or indirect taxes in the country, collect the money from you and give it back to you. Hence risk free rate should be surrogated by the yield on government securities.

Stock market can be taken as a surrogate of market and historical return from the stock market of a company over a long period of time can be taken as a measure of expected return from the market. Historical equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium. Stock market return in excess of risk free rate is market premium and β times market premium is the expected premium from the security. Expected return from a security as calculated by using CAPM equation is also the expected risk adjusted return (a return adjusted for its risk).

Security Market Line:

CAPM is most often used to determine what the fair price of an investment should be. The risky asset's rate of return using CAPM can be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value which can then be compared to its market price. This can help figure out whether a stock / security is over or under priced.

• All the correctly priced securities are plotted on the SML.
• The assets above the line are undervalued because for a given amount of risk (beta), they yield a higher return, their expected returns are higher than the point on the Security Market Line relative to their betas. Further, they are lesser risky than other securities providing the same return.
• The assets below the line are overvalued because for a given amount of risk, they yield a lower return, their expected returns are lower than the point on the Security Market Line relative to their betas. Further they are more risky than other securities providing the same return.