Question

What is the Capital Asset Pricing Model (CAPM)? Explain each variable in CAPM. What is the Security Market Line (SML)? Please feel free to expand on your answers.

Answer 1

Capital Asset Pricing Model (CAPM) - It is very important to know the value of an asset / stock before its investment. One best method to calculate that is through CAPM approach. This method helps in calculating the expected returns of the stock.

This method describes the relationship between risk of the stock, its price and the return.

The formula to calculate CAPM is Rf + Beta (Rm - Rf)

The variables of CAPM method are

Rf = risk free rate of an investment

Rm = The expected return of market portfolio

Beta = B = Stock's risk.

With this formula, we will be able to arrive with the expected return from an investment.

Security Market Line -

This is the line which shows graphical representation of CAPM on a chart. This helps presents the market risk in X axis and the expected returns of a particular security in Y axis. The market risk premium is identified by seeing line plotted on the chart.  

This method helps in technical analysis of a particular stock and identify whether it is overvalued or undervalued. This thereby helps the investors in taking important investment decisions.