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• It is set of principles describing how people behave in the market.
• It describes how Investor’s behavior should affect security prices rather than explaining what investors actually observe in the market.
Assumptions:
• The investors objective is to maximize the utility of wealth
• Investors make choices solely on the basis of risk and return
• Investors have homogeneous expectations
• Investors have identical one period time horizons
• Information is freely available
• There is risk free asset and investor can borrow and lend any amount of money at the risk free rate
• There are no taxes, transaction costs, or other market imperfections
• Total asset quantity is fixed and all assets are marketable and divisible
• Capital markets are in equilibrium
Capital Market Line (CML)
• Next step in deriving the asset pricing model is to define a set of criteria for identifying preferred investments
• It utilizes only the mean and variance expected return to identify the investment that dominate
• Using the mean as the measure of expected return and the standard deviation as the measure of risk, we can represent any investment in risk-return space as a single point
• Introduction of risk free asset with borrowing and lending at the risk free rate leads to the CML
• CML is a linear relationship between expected return and total risk
• The difference between the CML and the old efficient frontier of assets identifies the risk [email protected]
• The capital asset pricing model gives a relationship between a securities risk and return
• The excess of return earned on any other security is the risk premium or the reward for the excess risk pertaining to that security
• The market risk premium is the difference between Average Rate of Return on Market and Risk free rate.
Security Market Line (SML)
• The graphical version of CAPM is called SML
• It shows relationship between beta and required rate of return
• CAPM identifies security return net of the risk free rate as proportional to the expected net market return, where beta serves as the constant proportionality
• As a consequence of this relationship, all securities in equilibrium plot along straight line is called SML.
• It is an alternative to CML which will use beta as the independent variable and will accommodate both portfolios and individual assets
• SML has positive slope, indicating that the expected return increases with risk
• Expected return= Riskless rate + systematic risk premium which is proportional to its beta
• If individual asset and portfolios are priced correctly, then all currently priced assets must lie on the SML
• An asset lying above SML is undervalued because it offers a return higher than what is consistent with the systematic risk it carries.
• An asset lying below SML is overvalued because it offers a return lower than what is consistent with the systematic risk it carries
