Capital Asset Pricing Model

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.

The CAPM Formula
Problems with Capital Asset Pricing Model (CAPM)
By extension, once you've calculated the investment's fair value you can then compare it to its market price. If your price estimate is higher than the market's, you could consider the stock a bargain. If your price estimate is lower, you could consider the stock to be overvalued.

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then the expected return on the stock would be 15%.

15% = 5% + 2 (10% – 5%)

The Capital Asset Pricing Model (CAPM) is based on assumptions. First, the model assumes that a riskier asset will yield a higher return. But this is not necessarily true. A risky asset could decline in value. Second, historical data determines beta. The model assumes this historical data an accurate predictor of future results. But the asset’s future volatility may not necessarily reflect its past volatility.

Why it matters:

CAPM is most often used to determine what the fair price of an investment should be. When you calculate the risky asset's rate of return using CAPM, that rate can then be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value.

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Difference Between CML and SML. CML stands for Capital Market Line, and SML stands

 for Security Market Line. ... One of the differences between CML and SML, is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML. 

The formula for the slope of the CML is (expected return market - risk free rate)/standard dev. market. So we divide it by a measure of risk.

 In the SML the slope is just (expected return market portfolio - risk free rate), without dividing it by some measure of risk.Feb 8, 2008