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What Does Capital Asset Pricing Model - CAPM Mean? A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Investopedia explains Capital Asset Pricing Model - CAPM The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
Capital Market Line - CML
What Does Capital Market Line - CML Mean? 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. Investopedia explains Capital Market Line - CML 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. 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. This is achieved visually through the security market line (SML).
Security Market Line - SML
What Does Security Market Line - SML Mean? A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities. Also refered to as the "characteristic line".
or when using modern portfolio formation techniques. it is undervalued because the investor can expect a greater return for the inherent risk. . According to this metric. The x-axis represents the risk (beta). A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed. The rate of return is dependent on the standard deviation of the asset's returns and the slope of the characteristic line. and is very useful when employing the capital asset pricing model.Investopedia explains Security Market Line .the higher the returns you can expect to earn. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML. Characteristic Line What Does Characteristic Line Mean? A line formed using regression analysis that summarizes a particular security or portfolio's systematic risk and rate of return. which is represented by the asset's beta. the more risk you take on . The slope of the line. Investopedia explains Characteristic Line A characteristic line of a stock is the same as the security market line.SML The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. which is a measure of systematic risk. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. There is considerable controversy regarding the use of beta as a measure of risk and return. Efficient Frontier What Does Efficient Frontier Mean? A line created from the risk-reward graph. and the y-axis represents the expected return.as measured by variability in returns . comprised of optimal portfolios. determines the risk-return tradeoff.
. A beta of less than 1 means that the security will be less volatile than the market. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. a model that calculates the expected return of an asset based on its beta and expected market returns. and you can think of beta as the tendency of a security's returns to respond to swings in the market. Alpha What Does Alpha Mean? 1. Also known as "beta coefficient". A measure of performance on a risk-adjusted basis. or systematic risk. Investopedia explains Beta Beta is calculated using regression analysis. of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM). The excess return of the fund relative to the return of the benchmark index is a fund's alpha. but also posing more risk. Beta What Does Beta Mean? A measure of the volatility. Conversely. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example. it's theoretically 20% more volatile than the market.Investopedia explains Efficient Frontier The optimal portfolios plotted along the curve have the highest expected return possible for the given amount of risk. offering the possibility of a higher rate of return.2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). Many utilities stocks have a beta of less than 1. if a stock's beta is 1. 2. most high-tech Nasdaq-based stocks have a beta of greater than 1. A beta of 1 indicates that the security's price will move with the market..
If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the portfolio actually earns 15%. a similar negative alpha would indicate an underperformance of 1%. and the Sharpe ratio. standard deviation. Simply stated.0 means the fund has outperformed its benchmark index by 1%. emphasizing that risk is an inherent part of higher reward. All of these indicators are intended to help investors determine the risk-reward profile of a mutual fund. Modern Portfolio Theory . There are four basic steps involved in portfolio construction: -Security valuation -Asset allocation -Portfolio optimization -Performance measurement Markowitz Efficient Set What Does Markowitz Efficient Set Mean? A set of portfolios with returns that are maximized for a given level of risk based on mean-variance portfolio construction. Also called "portfolio theory" or "portfolio management theory." published in 1952 by the Journal of Finance.MPT What Does Modern Portfolio Theory . This 5% is the excess return over what was predicted in the CAPM model. it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. A positive alpha of 1. R-squared." Investopedia explains Modern Portfolio Theory . the portfolio's alpha would be 5%.MPT According to the theory. 2. Alpha is one of five technical risk ratios. . the others are beta. These are all statistical measurements used in modern portfolio theory (MPT).Investopedia explains Alpha 1. The efficient "solution set" to a given set of mean-variance parameters (a given riskless asset and a given risky basket of assets) can be graphed into what is called the Markowitz efficient frontier. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection. Correspondingly. alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return.MPT Mean? A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk.
Unsystematic Risk What Does Unsystematic Risk Mean? Company or industry specific risk that is inherent in each investment. The reason for this is that investors need to be compensated for taking on additional risk. Whereas this type of risk affects a broad range of securities. a U. Also known as "specific risk". Treasury bond is considered to be one of the safest investments and. government. Because the risk of investing in a corporate bond is higher. and is still a vital component of professional money management today. unsystematic risk affects a very specific group of securities or an individual security. Investopedia explains Unsystematic Risk For example. A key component of the risk mangement process is risk assessment. Even a portfolio of well-diversified assets cannot escape all risk. Investopedia explains Risk A fundamental idea in finance is the relationship between risk and return. The amount of unsystematic risk can be reduced through appropriate diversification. Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. when compared to a corporate bond.S. Also known as "un-diversifiable risk" or "market risk.Investopedia explains Markowitz Efficient Set The Markowitz efficient set is all of the portfolios on the efficient frontier. . "diversifiable risk" or "residual risk". is considered to be unsystematic risk. which involves the determination of the risks surrounding a business or investment. Systematic Risk What Does Systematic Risk Mean? The risk inherent to the entire market or entire market segment. The reason for this is that a corporation is much more likely to go bankrupt than the U. or those that generate the largest return for a given risk level. news that is specific to a small number of stocks. For example. such as a sudden strike by the employees of a company you have shares in. recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be mitigated only by being hedged. provides a lower rate of return. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment." Investopedia explains Systematic Risk Interest rates. This includes the possibility of losing some or all of the original investment. the greater the potential return. The mean-variance and subsequent efficient set theory at one time revolutionized portfolio management.S. investors are offered a higher rate of return. Risk What Does Risk Mean? The chance that an investment's actual return will be different than expected. The greater the amount of risk that an investor is willing to take on. The theory of mean-variance portfolios lead to the capital asset pricing model. and remains a core lecture in any economist's university years.
therefore. According to the risk-return tradeoff. whereas high levels of uncertainty (high risk) are associated with high potential returns. Risk-Return Tradeoff What Does Risk-Return Tradeoff Mean? The principle that potential return rises with an increase in risk. The goal instead is to find an appropriate balance .Return What Does Return Mean? The gain or loss of a security in a particular period. the greater the potential for higher return . see 1040 Form. invested money can render higher profits only if it is subject to the possibility of being lost.and loss. . Taking on some risk is the price of achieving returns. Return is also used as an abbreviation for income tax return. but still allows you to sleep at night. It is usually quoted as a percentage. The return consists of the income and the capital gains relative on an investment. Investopedia explains Risk-Return Tradeoff Because of the risk-return tradeoff. Investopedia explains Return The general rule is that the more risk you take.one that generates some profit. if you want to make money. you can't cut out all risk. Low levels of uncertainty (low risk) are associated with low potential returns. you must be aware of your personal risk tolerance when choosing investments for your portfolio.
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