An example:

Equally-weighted two-stock portfolio

• Create a portfolio with 50% invested in HT and 50% invested in
Collections.
• The beta of a portfolio is the weighted average of each of the stock’s
betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215
Calculating portfolio required returns

• The required return of a portfolio is the weighted

average of each of the stock’s required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

• Or, using the portfolio’s beta, CAPM can be used to

solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215)
Factors that change the SML

• What if investors raise inflation expectations by

3%, what would happen to the SML?
ki (%)
D I = 3% SML2
18
SML1
15

11
8

Risk, βi

0 0.5 1.0 1.5

Factors that change the SML

• What if investors’ risk aversion increased, causing the

market risk premium to increase by 3%, what would
happen to the SML?
ki (%)
D RPM = 3% SML2

18
SML1
15

11
8

Risk, βi

0 0.5 1.0 1.5

Verifying the CAPM empirically
• The CAPM has not been verified completely.
• Statistical tests have problems that make verification almost
impossible.
• Some argue that there are additional risk factors, other than the
market risk premium, that must be considered.
More thoughts on the CAPM
• Investors seem to be concerned with both market risk and total risk.
Therefore, the SML may not produce a correct estimate of ki.
ki = kRF + (kM – kRF) βi + ???
• CAPM/SML concepts are based upon expectations, but betas are
calculated using historical data. A company’s historical data may not
reflect investors’ expectations about future riskiness.