In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset,

if that asset is to be added to an already welldiversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

Security market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

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The security market line (SML) represents in a graphical form, the relationship between the risk of an asset as measured by its beta and the required rates of return for individual securities. The SML equation is essentially the CAPM, ri = rRF + bi(rM - rRF).

m. The slope of the SML equation is (rM - rRF), the market risk premium. The slope of the SML reflects the degree of risk aversion in the economy. The greater the average investors aversion to risk, then the steeper the slope, the higher the risk premium for all stocks, and the higher the required return.

What is CAPM? The CAPM is an equilibrium model that specifies the relationship between risk and required rate of return for assets held in well-diversified portfolios. It is based on the premise that only one factor affects risk. What is that factor? The CAPM is a single factor model. "Cap-M" looks at risk and rates of return and compares them to the overall stock market. If you use CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do take risks, expect to be rewarded. It also assumes that investors are "price takers" who can't influence the price of assets or markets. With CAPM you assume that there are no transactional costs or taxation and assets and securities are divisible into small little packets. Had enough with the assumptions yet? One more. CAPM assumes that investors are not limited in their borrowing and lending under the risk free rate of interest. By now you

likely have a healthy feeling of skepticism. We'll deal with that below, but first, let's work the CAPM formula. Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly. Each company also has a beta. You can find a company's beta at the Yahoo!! Stock quote page. A company's beta is that company's risk compared to the risk of the overall market. If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall market. Ks = Krf + B ( Km - Krf)

Ks = The Required Rate of Return, (or just the rate of return). Krf = The Risk Free Rate (the rate of return on a "risk free investment"Treasury Bill) B = Beta (see above) Km = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.) Km - Krf = Market Premium

What are the assumptions of the CAPM? Investors all think in terms of a single holding period. All investors have identical expectations. Investors can borrow or lend unlimited amounts at the risk-free rate. All assets are perfectly divisible. There are no taxes and no transactions costs. All investors are price takers, that is, investors buying and selling wont influence stock prices. Quantities of all assets are given and fixed. What are two potential tests that can be conducted to verify the CAPM? Beta stability tests Tests based on the slope of the SML Are there problems with the CAPM tests? yes Richard Roll questioned whether it was even conceptually possible to test the CAPM. Roll showed that it is virtually impossible to prove investors behave in accordance with CAPM theory. What are our conclusions regarding the CAPM? It is impossible to verify. Recent studies have questioned its validity. Investors seem to be concerned with both market risk and stand-alone risk. Therefore, the SML may not produce a correct estimate of ri. CAPM/SML concepts are based on expectations, yet betas are calculated using historical data. A companys historical data may not reflect investors expectations about future riskiness. Other models are being developed that will one day replace the CAPM, but it still provides a good framework for thinking about risk and return. The CAPM allows focus on the risk that is important in asset pricingmarket risk. However, there are some drawbacks to applying the CAPM.

(a) A beta is an estimate of systematic risk. For stocks, the beta is typically estimated using historical returns. But the estimate for beta depends on the method and period in which is it is measured. For assets other than stocks, beta estimation is more difficult. (b) The CAPM includes some unrealistic assumptions. Like, it assumes that all investors can borrow and lend at the same rate or all the investors have the homogeneous expectations. But this assumption of homogeneous expectation is unrealistic even if all the investors are equally & fully informed. (c) In studies of the CAPM applied to common stocks, the CAPM does not explain the differences in returns for securities that differ over time, differ on the basis of dividend yield, and differ on the basis of the market value of equity (the so called size effect).