The capital asset pricing model (CAPM) and the security market line (SML) are used to gauge the expected returns of securities given levels of risk. The concepts were introduced in the early 1960s and built on earlier work on diversification and 澳洲幸运5官方开奖结果体彩网:modern portfolio theory. Investors sometimes use CAPM and SML to evaluate a security—in terms of whether it offers a favorable return profile 𓄧against its level of risk—before including the security within a larger portfolio.

Capital Asset Pricing Model

The 澳洲幸运5官方开奖结果体彩网:capital asset pricing model (CAPM) is a formula that describes the relationship between the 澳洲幸运5官方开奖结果体彩网:systematic risk of a security or a portfolio and expected return. It can also help measure the volatility or beta of a securi♔ty relative to others and compared to the overall market.

Mathematically, the CAPM formula is the risk-free 澳洲幸运5官方开奖结果体彩网:rate of return added to the beta of the security or portfol🌺io multiplied by the expected market return minus the risk-free rate of return:

$\begin{aligned} &\text{Required Return} = \text{RFR} + \beta_\text{stock/portfolio} \times ( \text{R}_\text{market} - \text{RFR} ) \\ &\textbf{where:} \\ &\text{RFR} = \text{Risk-free rate of return} \\ &\beta_\text{stock/portfolio} = \text{Beta coefficient for the stock or portfolio} \\ &\text{R}_\text{market} = \text{Return expected from the market} \\ \end{aligned}$​Required Return=RFR+βstock/portfolio​×(Rmarket​−RFR)where:RFR=Risk-free rate of returnβstock/portfolio​=Beta🐼 coefficient for the&nbsౠp;stock or portfolioRmarket​=Return expected fro🐟m the market​

澳洲幸运5官方开奖结果体彩网:The CAPM formula yields the expected return of the security. The beta of a security measures the systematic risk and its sensitivity relative to changes in the market. A security with a beta of 1.0 has a perfect positive correlation with its market. This indicates that when the market increases or decreases, the security should increase or decrease by the same percentage amount. A security with a beta higher than 1.0 carries greater systematic risk and 澳洲幸运5官方开奖结果体彩网:volatility than the overall market, and a security with a beta less than 1.0, has l🅘ess systematic risk and volatility than the market.

Security Market Line

The 澳洲幸运5官方开奖结果体彩网:security market line (SML) displays the expected return of a security or portfolio. It is a graphical representation of the CAPM formula and 澳洲幸运5官方开奖结果体彩网:plots the relationship between the expected return and beta, or systematic risk, associated with a security. The expected return of securities is plotted on the y-axis of the graph, and the beta of securities is plotted on the x-axis. The slope of the relationship plotted is known as the 澳洲幸运5官方开奖结果体彩网:market risk premium (the difference between the expected return of the market and the risk-free rate of return), and it represents the 澳洲幸运5官方开奖结果体彩网:risk-return tradeoff of a security or portfolio.

CAPM, SML, and Valuations

Together, the SML and CAPM formulas are useful in determining if a security being considered for investment offers a reasonable expected return for the amount of risk taken on. If a security’s expected return versus its beta is plotted above the security market line, it is considered 澳洲幸运5官方开奖结果体彩网:undervalued, given the risk-return tradeoff. Conversely, if a security’s expected return versus its systematic risk is plotted below the SML, it is 澳洲幸运5官方开奖结果体彩网:overvalued because the꧅ investor would acc🍌ept a smaller return for the amount of systematic risk associated.

The SML can be used to compare two similar 澳洲幸运5官方开奖结果体彩网:investment securities that have approximately the same return to determine which of the two securities carries the least amount of inherent risk relative to the expected re♔turn. It can als🐽o compare securities with equal risk to determine if one offers a higher expected return.

While the CAPM and the SML offer important insights and are widely used in 澳洲幸运5官方开奖结果体彩网:equity valuation and comparison, they are not standalone tools. There are additional factors—other than the expected return of an investment over the risk-free rate of return—that sh🐻ould be considered when making investme🎉nt choices.