CAPM & SML

Presented by:
Abhishek Sharma(06)
Ashima Gupta(15)
Hardik Gupta(24)
CAPM
The capital asset pricing model (CAPM) is a model that
describes the relationship between systematic risk
and expected returns for assets, particularly stocks.

CAPM is widely used throughout finance for the pricing of

risky securities, generating expected returns for assets
given the risk of those assets and calculating costs of
capital.
Formula
The formula for calculating the expected return of an asset
given its risk is as follows:

E(Ri) = RFR+ i[E(Rm)-RFR]

RFR= Risk Free Return

= Beta of the Security
E(Rm)= Expected Market Return
BETA ()
A measure of the volatility, or systematic risk, of a security

or a portfolio in comparison to the market as a whole.

Beta is used in the capital asset pricing model (CAPM), a

model that calculates the expected return of an asset based

on its beta and expected market returns.

Also known as "beta coefficient.

Beta is calculated using regression analysis

Value of Beta
If Beta = 1: If Beta of the stock is one, then it has the same
level of risk as the stock market.
If Beta > 1: If the Beta of the stock is greater than one,
then it implies higher level of risk and volatility as
compared to the stock market.
If Beta >0 and Beta<1: If the Beta of the stock is less than
one and greater than zero, it implies the stock prices will
move with the overall market, however, the stock prices
will remain less risky and volatile.
 Example
Using the CAPM model and the following assumptions, we can compute the
expected return for a stock:

The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The
expected market return over the period is 10%, so that means that the
market risk premium is 8% (10% - 2%) after subtracting the risk-free rate
from the expected market return. Plugging in the preceding values into the
CAPM formula above, we get an expected return of 18% for the stock:

Ans: 18% = 2% + 2 x (10%-2%)

Security Market Line (SML)
SML shows the trade off between risk and expected

return as a straight line intersecting the vertical axis

i.e.: Zero risk point at a risk free rate.
Example
Lets assume the current risk-free rate is 4.75%, and the expected market return

is 15.50%. Thus, the SML equation will be as follows:

E(Ri) = 4.75+bi(15.50-4.75) = 4.75+10.75bi

Suppose that Security A has a beta of 0.6, and Security B has a beta of 1.2. The

expected return of Security A is 11.20%, and the expected return of Security B

is 17.65%.

E(RA) = 4.75+10.750.6 = 11.20%

E(RB) = 4.75+10.751.2 = 17.65%

So, lower risk (lower beta) means lower expected return and vice versa.
Difference between CML & SML
Advantages & Disadvantages
Explicitly adjusts for systematic risk

Applicable to all companies as long as we compute beta

Disadvantages:

Have to estimate the expected market risk premium, which does vary over

time

Have to estimate beta, which also varies over time

We are replying on the past to predict the future, which is not always reliable
Shift in SML
When a shift in the SML occurs, a change that affects all
investments' risk versus return profile has occurred. A shift
of the SML can occur with changes in the following:

Expected real growth in the economy.

Capital market conditions.

Expected inflation rate.

Conclusion
Investors differ in their willingness to accept risk for a greater
return. But if investors are willing to invest in the stock market,
then they are willing to assume some risk. What the capital asset
pricing model provides is a consistent means to price risk
premiums. If you are willing to accept higher risks to get higher
returns, then it makes sense to demand a higher return for a
higher risk; otherwise, why take the higher risk. By comparing
the beta of a stock and its historical return with that of the
general market, you can determine whether the return of a stock
is worth its risk.