Security Market LineVS

Capital Market Line

Presented By : -

Leena Jadhav21

Priyanka Shelatkar48

Sameet Gajakosh12

Sagar Lahoti29

Sushil Ingle28

Capital Asset Pricing Model

• The Capital Asset Pricing Model was the work of William Sharpe, a student of Harry Markowitz at the University of Chicago.

• The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced the way they are.

• CAPM is an hypothesis.

6

Return%

Beta Coefficient

Rf

Security MarketLine

BM=1.0

km

MarketPremiumfor risk

Real Return

Premium for expected inflation

Required return = Rf + bs [kM - Rf]

Capital Asset Pricing Model

• This model is an equilibrium based model.• It is called a single-factor model because the slope of the

SML is caused by a single measure of risk … the beta.• Although this model is a simplification of reality…it is

robust (it explains much of what we see happening out there) and it enjoys widespread use in a great variety of applications.

• Although it is called a ‘pricing model’ there are not prices on that graph….only risk and return.

• It is called a pricing model because it can be used to help us determine appropriate prices for securities in the market.

Capital Asset Pricing Model

Assumptions of 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 won’t influence stock prices.

• Quantities of all assets are given and fixed.

• There are no frictions in the capital market (i.e., no taxes, no transaction costs, no restrictions on short-selling).

Using the CAPM to Price Stock

• The CAPM is a ‘fundamental’ analyst’s tool to estimate the ‘intrinsic’ value of a stock.

• The analyst needs to measure the beta risk of the firm by using either historical or forecast risk and returns.

• The analyst will then need a forecast for the risk-free rate as well as the expected return on the market.

• These three estimates will allow the analyst to calculate the required return that ‘rational’ investors should expect on such an investment given the other benchmark returns available in the economy.

Practical Use of the CAPM

• Regulated utilities justify rate increases using the model to demonstrate that their shareholders require an appropriate return on their investment.

• Used to price initial public offerings (IPOs).• Used to identify over and under value securities.• Used to measure the riskiness of securities/companies.• Used to measure the company’s cost of capital. (The

cost of capital is then used to evaluate capital expansion proposals).

• The model helps us understand the variables that can affect stock prices…and this guides managerial decisions.

• The capital market line results from the combination of the market portfolio and the risk-free asset. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier.

• The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.

• A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.

• The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier.

Capital Market Line

Capital Market Line

• Line from RF to L is capital market line (CML)

• x = risk premium

= E(RM) – RF

• y = risk = M

• Slope = x/y

= [E(RM) - RF]/M

• y-intercept = RF

E(RM)

RF

M

L

M

y

x

Risk

Capital Market Line

• Slope of the CML is the market price of risk for efficient portfolios, or the equilibrium price of risk in the market

• Relationship between risk and expected return for portfolio P (Equation for CML):

pM

Mp

RF)R(ERF)R(E

Security Market Line

• The security market line (SML) is the graphical representation of the Capital Asset Pricing Model. It displays the expected rate of return of an individual security as a function of systematic, non-diversible risk (its beta).

• When used in portfolio management, the SML represents the investment's opportunity cost (investing in a combination of the market portfolio and the risk free asset).

• The Y-intercept (beta=0) of the SML is equal to the risk free interest rate. The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time:

Security Market Line

• CML Equation only applies to markets in equilibrium and efficient portfolios

• The Security Market Line depicts the tradeoff between risk and expected return for individual securities

• The SML is the line that reflects an investment’s risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta.

• Under CAPM, all investors hold the market portfolio• Equation for expected return for an individual stock similar to CML

Equation:

RF)R(ERF

RF)R(ERF)R(E

Mi

M

M,i

M

Mi

Security Market Line

• Beta = 1.0 implies as risky as market

• Securities A and B are more risky than the market Beta > 1.0

• Security C is less risky than the market Beta < 1.0

AB

C

E(RM)

RF

0 1.00.5 1.5

SML

BetaM

E(R)

SML and Asset Values

ErUnderpriced SML: Er = rf + (Erm – rf)

Overpriced

rf

Underpriced expected return > required return according to CAPM lie “above” SML

Overpriced expected return < required return according to CAPM lie “below” SML

Correctly priced expected return = required return according to CAPM lie along SML

β

Advantages and Disadvantages of SML

• Advantages: 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

• Jensen’s Index is the vertical distance from the SML.

• Evaluation of Expected Returns:

• Evaluation of Past Returns:

SML on the Return

Return Expected Expected

)β]r)[E(r(r )E(r J jFMFjj

]β)rr(r[rJ jFMFj

Jensen Index(Sometimes Called Jensen’s Alpha)

• The Jensen Index is sensitive only to depth and not to breadth: Depth: Magnitude of excess returns. Breadth: Magnitude of residual variance (e.g., Is

the portfolio well diversified?)• Note: Since beta is the risk measure:

Only systematic risk, and not residual variance is relevant.

The Jensen Index has been used for individual securities as well as portfolios. (No one expects individual securities to be well diversified).

Jensen Index (…Continued)

0

2

4

6

8

10

12

14

16

18

0 1 2 3

Expected Return

SML

Beta Coefficient

+Jj

-JjE(rM)

rF

The Jensen Index:A Graphical Illustration