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Capital asset pricing model - Coggle Diagram
Capital asset pricing model
Describes the relationship between systematic risk and expected return for assets
CAPM is widely used for the pricing of risky securities, generating expected returns for assets given their risk and calculating costs of capital
In 1964 William Sharpe developed the CAPM that exhibited assumptions in that the efficient portfolio has to be the market portfolio, based on this, typical investors must keep the market portfolio leveraged or deleveraged to realise their desired risk - this is done with the use of a function of risk named Beta
The CAPM model states that the expected return of an investment is defined by the rate on a risk free security (such as a government bond) plus a risk premium
Systematic risk
Interest rate changes
Inflation rate changes
Tax rate changes
Economic conditions
Political conditions
Undiversifiable
Unsystematic risk
Quality of mangement
Profit margins with companies
Supply factors
Demand factors
Company / investment specific
Diversifiable
Systematic or market risk impacts on the economy in general and cannot be eliminated
A diversified investor will still face some risk and will seek a return commensurate with that level of systematic risk. If the investor has included an investment in a risk free security, it is possible to caluclate returns achievable and risk faved
If a new investment had the same level of systematic risk, it would only be included if it offered a higher return and this gives the minimum acceptable return for the investment based upon its level of systematic risk
Securities market line
The line which shows the relationship between relative levels of risk (B) and expected returns
The securities market line is drawn on a chart that creates a graphical representation of the CAPM, showing different levels of various investments plotted against the expected return of the whole market
The securities market line is an investment evaluation tool derived from the CAPM, a model that describes risk-return relationships for securities, and is based on the assumptions that investors have to be compensated for the time value of money (with the inclusion of the risk free rate) and the corresponding level of risk associated with any investment, referred to as the risk premium
The securities market line is employed by investors evaluating an investment for potential inclusion in a portfolio in terms of whether the security offers a higher expected return against its level of risk
If it appears above the SML it is considered undervalued because it offers a greater return against its inherent risk
If the security is plotted below the SML, it is considered overvalued in price because the expected return does not overcome the inherent risk and it should not be included
The SML is also used in comparing two similar securities offering approximately the same return, in order to determine which of the two securities involves the least amount of market risk in relation to the expected return
Similarly the SML can be used to compare two investments of equal risk to see which one offers the highest expected return commensurate with that level of risk
