The Capital Asset Pricing Model. Review. Review of portfolio diversification Capital Asset Pricing Model Capital Market Line (CML) Security Market Line (SML). Capital Asset Pricing Model (CAPM). It is the equilibrium model that underlies all modern financial theory.
Example:What determines the market risk premium?
b tells you how much the security’s rate of return changes when the return on the market portfolio changes
SML: ri = rf + i[E(rm) - rf]
i= [COV(ri,rm)] / m2
Slope SML = E(rm) - rf
= market risk premium
E(rm) - rf = .08 rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%