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Unit-5_CAPM, CML & SML

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12 views

Unit-5_CAPM, CML & SML

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tyagiyash952
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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INVESTMENT ANALYSIS AND PORTFOLIO

MANAGEMENT

Dr. Umra Rashid


Assistant Professor - SS
School of Business
CAPM, CML & SML
Meaning of CAPM
• It is a framework which shows the relationship between
expected return and systematic risk of individual
assets/securities and portfolios. It is developed by
William Sharpe, John Lintner and Mossin.
• It suggests how assets are priced in the market place. It
uses the results of capital market theory to derive the
relationship between expected return and systematic risk
of individual assets/securities and portfolios. The capital
market theory tells how assets should be priced in the
capital markets if all investors behave rationally.
Contd…

• CAPM is based on the rational behavior of investors. Here,


rational behaviour implies that investors are risk averse by
nature and always prefer extra returns known as risk
premium for the risk assumed by them as compared to the
returns expected from risk free avenues.
• E(r) = Rf+B(Rm-Rf)
Where E(r) = Expected Return
Rf = Risk Free Rate
Rm = Market Return
B = Beta
Assumptions of CAPM

1. investors are risk averse.


2. investors want to maximize the wealth and choose a
portfolio solely on the basis of risk and return
assessment.
3. Investors can borrow or lend an unlimited amount of
funds at risk free rate of interest.
4. Securities are perfectly divisible and liquid.
5. There is no transaction cost or tax.
6. Investors have identical estimates of risk and return of
all securities.
7. There is perfect competition in market.
Implication of CAPM

CAPM has implications for:


a)Risk -return relationship of efficient portfolio.
b)Risk-return relationship of individual security.
c)Identification of under priced or over priced assets
traded in market.
d)Capital budgeting or cost of capital
Elements of CAPM
• There are two elements of CAPM:
1)Capital Market Line (CML)
2)Security Market Line (SML)
1. Capital Market Line (CML)
• It is a line representing various efficient portfolios created by
combining risk free and risky assets/securities. All the
portfolios lying on this line are efficient in themselves as these
provide maximum returns for a given level of risk or have
minimum risk for a given level of returns.
• The line used in the capital
asset pricing model to present the rates of return for efficient
portfolios. These rates will vary depending upon the risk-
free rate of return and the level of risk (as measured by beta) f
or a particular portfolio.
The capital market line shows a positive linear relationship
between returns and portfolio betas.
• Return= Rf+(Rm-Rf)*S.D. of Individual security/S.D. of
Market return
Security market line
• SML is a graphical version of CAPM. It means SML
represents the relationship between beta and the
expected rate of return of a security.
• The shape of SML shows that the risk and the
risk premium have a linear relations. It means
when an investor moves out of the risk free asset
towards riskier assets, the beta increases to B1,
B2 and B3. At the same time return also
increases to R1, R2 and R3. Hence, it can be
shown risk premium is low for the low beta and
higher for high beta.
• It shows only those securities which are correctly
priced in view of the systematic risk associated
with the security. SML is also known as security
characteristic line.
Difference between CML and SML

• CML shows the relationship between total risk and


expected return of portfolio whereas SML shows the
relationship between systematic risk and expected
return of a security.
• Standard deviation is the measure of risk in CML
whereas Beta determines the risk factors of the SML.
• CML graphs define efficient portfolios and SML
graphs define both efficient and non efficient
security.
Limitation of CAPM
• The calculation of factor is very tedious as lot of data is
required. The beta factor can be found by examining the
security’s historical returns relative to the return of the
market portfolio. Further, the beta factor may or may not
reflect the future variability of returns.
• The assumptions of the CAPM are hypothetical and are
impractical. For example: the assumption of borrowing
and lending at the same rate is imaginary.
• The required rate of return specified by the model can be
viewed only as a rough approximation of the required rate
of return.
THANK YOU

14

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