CAPM & the SML
The Capital Asset Pricing Model (CAPM) assumes only one efficient portfolio, the market portfolio.
CAPM and the CML are more strict than simple Mean-Variance and the CAL.
CAPM and CAL similarities:
Risk averse investors.
Shared investor assumptions for expected returns, variances and standard deviations, and covariances of returns.
The above variables are the only inputs required to calculate the efficient frontier.
No taxes and no transaction costs.
CAPM additional assumptions:
All investors have the same CAL.
No restrictions for borrowing and lending at the risk free rate.
No restrictions on short-selling.
Trading volume does not change prices.
- The CML is the efficient market portfolio, but the CAPM can describe the expected returns for all assets and portfolios.
CAPM: E(Ri) = RF + βi[E(RM) - RF]
E(Ri) = Return for asset "i"
RF = Risk-free rate of return
E(RM) = Expected return of the market portfolio
βi = The asset's beta
Beta is the asset's sensitivity to the return on the market portfolio
Beta is a measure of an asset's risk relative to market portfolio, as asset's with a beta above 1 are considered riskier than the market and beta's below 1 are considered less risky than the market.
β = Cov(Ri,RM)/σM2
Security Market Line (SML): Line produced by the CAPM equation for asset "i"
SMLs & Efficient Markets: In an efficient market securities are correctly priced when the expected risk and expected return equal the SML price of risk.
- CFA Level 2: Portfolio Management – Introduction
- Mean-Variance Analysis Assumptions
- Expected Return and Variance for a Two Asset Portfolio
- The Minimum Variance Frontier & Efficient Frontier
- Diversification Benefits
- The Capital Allocation Line – Introducing the Risk-free Asset
- The Capital Market Line
- CAPM & the SML
- Adding an Asset to a Portfolio – Improving the Minimum Variance Frontier
- The Market Model for a Security’s Returns
- Adjusted and Unadjusted Beta
- Multifactor Models
- Arbitrage Portfolio Theory (APT) – A Multifactor Macroeconomic Model
- Risk Factors and Tracking Portfolios
- Markowitz, MPT, and Market Efficiency
- International Capital Market Integration
- Domestic CAPM and Extended CAPM
- Changes in Real Exchange Rates
- International CAPM (ICAPM) - Beyond Extended CAPM
- Measuring Currency Exposure
- Company Stock Value Responses to Changes in Real Exchange Rates
- ICAPM vs. Domestic CAPM
- The J-Curve – Impact of Exchange Rate Changes on National Economies
- Moving Exchange Rates and Equity Markets
- Impacts of Market Segmentation on ICAPM
- Justifying Active Portfolio Management
- The Treynor-Black Model
- Portfolio Management Process
- The Investor Policy Statement