Capital Asset Pricing Model: Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM) is used to calculate the projected return on the equity of a single company. CAPM is based on risk free rate, the expected return rate on the market and beta coefficient of a single portfolio and security.

Re = Rf + β [E(Rm) - (Rf)]

According to the formula, Re represents the Return on Equity, Rf is for the risk-free rate, E(Rm) denoted to expected rate of return on the market, and β is the beta coefficient and E(Rm) - Rf is the difference among the expected market rate of return and the risk-free rate, is known as the market premium (Phillips, 2007).

The total risk of stock is divided in two parts: the systematic risk, which is risk linked with the market and is impossible to

CAPM is basically used to confirm the theoretically suited required rate of return to the asset when the asset is considered to be added towards a well performing existing portfolio. Capital Market Line is used for determining the return rate of specific efficient portfolios. Basically, this analysis depends on risk free return rate and amount of the risk involved within particular portfolio. Its formula is shown as:

CML∶E (r)=rf+ σ (E (rM)- rf)/σM

Capital market line is the result from a combination of market portfolio as well as risk free security or asset (which is L point). All the points along CML have greater risk and return profiles to any portfolio at efficient frontier, along with an exception of Market Portfolio that is the point on efficient frontier towards which the Capital market Line is tangent. From the perspective of CML, the M portfolio is composed entirely of the market and risky asset, as well as has not holding of risk free asset, that is, the money is actually neither invested, nor taken or borrowed from account of money market. The points to left and above of CML are considered infeasible, whereas the points to below or right are actually attainable but are inefficient. The point R denotes addition of the leverage that creates the levered portfolio which is also at CML (Snyder,

This is the main point of similarity among Capital Asset Pricing Model and the Capital Market line. Basically, the Capital Asset Pricing Model (CAPM) is significant part of the portfolio theory, which discusses capital market line and security market line. Thus, the CAPM is served as base for both CML and SML.

On the other hand, there exists point of difference at several points when we talk about the CAPM and CML. First, Capital Market Line is line which is used for the rate of return that depends upon the risk free return rate and risk level for a particular portfolio. However, Security market line which is formed by CAPM is denoted as Characteristic line. It is graphical representation of risk and the return of market at given time. Second, in Capital Market Line, standard deviation is used for the risk measurement of a portfolio and in the Security market line, the beta coefficient is used to find out about factor of risk. Third, the graph of Capital market Line demonstrates about only efficient portfolios; while the graph of Security Market Line demonstrates both efficient and the non-efficient portfolios. Fourth, when take measurement of risk factors, the CML is considered as superior this is not in the case of SML. Fifth, Capital Market Line only determines the risk free assets and market portfolio; whereas, Security market