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.
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The Capital Asset Pricing Model
Risk premium on the the market depends on the average risk aversion (A) of all market participants.
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
The Beta of a Portfolio in CAPM
E(rm) - rf = .08rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%