CAPITAL ASSET PRICING MODEL

(CAPM)
 Capital Asset Pricing Model

The capital asset pricing model explains why

assets are priced the way they are.
It states that the expected risk premium on
each investment is proportional to its beta.

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 Capital Asset Pricing Model
Assumptions

No taxes on returns or transaction costs on trades.

Investors can borrow and lend at risk-free rate without
any limitation and they are free to short sell any asset
in any quantity.
Investors have homogeneous expectations regarding
mean returns, correlations and variances of risky
assets.
All assets are tradable and can be bought and sold in
any quantity without impacting prices.
The model continues with the main assumptions of
mean variance theory
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 Capital Asset Pricing Model
Under CAPM, expected returns of all assets
and portfolio whether efficient or not, can be
described through the following equation

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 Capital Asset Pricing Model
All the implications of CAPM can be
demonstrated graphically through Security
Market Line (SML), which is a visual
presentation of the relationship between
expected rate of return and risk of an asset.

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 The SML and Undervalued and
Overvalued Assets
A security is undervalued if its estimated
return > required or expected return. Hence it
will plot above the SML.
A security is overvalued if its estimated return
< required or expected return. Hence it will
plot below the SML.
A security is fairly priced if its estimated return
= required or expected return. Hence it will
plot on SML.

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Consider the required and estimated return calculated in Numerical Examples 10
and 11 to determine which securities are overvalued, undervalued or fairly valued.

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 Using SML to Buy/Sell Securities
Alpha
The overvaluation or undervaluation of a security is
judged on the basis of the difference between the
estimated and the required returns of a security.
This difference between estimated return and
expected or required return is sometimes referred to
as a stocks alpha or its excess return.
Alpha can be positive (if the stock is undervalued) or
negative (if the stock is overvalued). Alpha equal to
zero indicates that the stock is located on the SML and
is fairly valued in line with its systematic risk.
2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 2016 Cengage Learning India Pvt. Ltd. All
rights reserved.
 2016 Cengage Learning India Pvt. Ltd. All
rights reserved.