What is the CAPM and of what use is it?

In these days and years, people would like lending money to banks or investing money in common stock portfolios to earn as much money as they can because money in pockets is less valuable than in banks. However, unexpected risks will be occurred while people invest in stock markets or else where. In other words, there is a chance to lose money. Most investors, therefore, would use information such as financial analysis and researches to estimate the risk of the portfolio they form. Capital Asset Pricing Model (CAPM) is one of the models which can estimate the expected return and risk of portfolios.

This essay is divided into 6 sections. Following this introduction is the definition and explanation of CAPM. Hence the interpretation of Security Market Line is shown. After that the focus goes to the Limitation and Assumption of CAPM. The second last section looks at the use of CAPM. Finally, a conclusion is drawn. The definition of Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) was created by three economists who are William Sharpe, John Lintner and Jack Treynor in the mid-1960s.

It is an economic model which is used to be valuing stocks, securities, derivatives and assets by relating risk and expected return. In finance, by using the capital asset pricing model (CAPM), the adding of the rate of return of an asset to an already well-diversified portfolio, required as theoretically appropriate, can be determined, given the non-diversifiable risk of that asset. The risk affecting the return of an asset can be separated into two categories by CAPM. The first type is called systematic risk (also known as market risk and non-diversifiable risk) which is caused by general economic uncertainty.

The sensitivity of an asset to systematic risk which in the financial industry, mostly symbolized by the quantity beta (i?? ), is taken into account together with the expected return of the market and the expected return of a theoretical risk-free asset when applying the model. The second type is called unsystematic risk. There is no long-term average return for this kind of risk. CAPM states that the expected return is equal to the rate on a risk-free security plus a risk premium. Therefore, the investment should not be accepted and should be rejected if the expected return does not meet the required return.

The Security Market Line (SML) is a representation of the Capital Asset Pricing Model (CAPM) in portfolio theory. Most useful information such as the expected return of an individual security and the risk-free interest rate can be shown in this graph. In the graph of SML, the Y-Intercept of the SML represents the expected return and the X-intercept represents the beta which is the risk of the portfolio and the slope of the SML is used to determine the market risk premium and reflects investors' degree of risk aversion at a given time. In other words, (rm – rf) is the slope of SML.

When an investor determines if an asset being considered for a portfolio offers a reasonable expected for risk, the security market line is such a useful tool. In the SML graph, every individual security is plotted. Two possible solutions which are overvalued and undervalued, therefore, will be drawn. Former means that investors can expect less return for the amount of risk assumed because the security's risk versus expected return is plotted below the SML and later means that investors can be expecting a larger return for the inherent risk because the security's risk versus expected return is plotted above the SML.