Hemant Manuj

CAPITAL MARKETS
DR. HEMANT MANUJ

8-May-22 1
CAPITAL ASSET PRICING MODEL

Hemant Manuj 8-May-22 2

 CONTENTS

➢ The Capital Asset Pricing Model

➢ Assumptions and Extensions of CAPM

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 CAPM

➢ For equilibrium, all securities as well as the market portfolio should offer the same risk
reward ratio, else investors will move from the less attractive to more attractive securities
➢ For any security i, the excess return per unit of systematic risk should be the same
i.e., E(Ri) / Cov i,M = E(RM)/ σM2
or, E(Ri) = E(RM) * Cov i,M / σM2
or, E(ri) - rf = {E(rM) - rf } * Cov i,M / σM2
or, E(ri) = rf + βi {E(rM) - rf } where βi = Cov i,M / σM2
known as the Capital Asset Pricing Model (CAPM)

➢ How many stocks should you own in a portfolio?

https://www.youtube.com/watch?v=H3Q8a9imiFs&list=PLL0d05lkGCUu6XGM-GBFb-
M0y4hUP9MLx&index=22&t=0s
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 SECURITY MARKET LINE

➢ The Security Market Line (SML) is the relationship

between the risk premium of an asset in relation to
its beta
❖ Valid for the systematic risk portion of individual
assets as well as efficient portfolios
❖ Beta measures the contribution of the security to
the risk of the market portfolio

➢ The capital market line (CML) is the relevant

relationship for efficiently diversified portfolios
(composed of risky and risk free portfolios)

Source: Investments by Bodie et al

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 SECURITY MARKET LINE

➢ SML represents the fair value of the asset

❖ Over-priced assets will plot below the SML
❖ Under-priced assets will plot above the SML

➢ Alpha : Difference between the fair return and

the expected return on an asset. E.g.
➢ If rm = 14%, β = 1.2, rf = 6%, then fair return (ri) =
15.6%
➢ If expected returns = 17%, α = 17% - 15.6% = 1.4%

➢ Portfolio managers can generate alpha, based

on differential inputs, compared to market as a
whole Source: Investments by Bodie et al

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