Capital Asset Pricing Model Case Study

1) Discuss and Differentiate

i) Capital market line- it’s a tangent line which used in the capital asset pricing model (CAPM) to derive the rates of return and the level of risk i.e standard deviation for efficient portfolios which is depending on the risk free rate of return. It is derived by the formula:

CML : E(R) = Rf+ standard deviation * E(RM)-RF/standard deviation of M

Rm is the return of the market rate

E(R) is the expected return of the security

Rf is the risk free rate

ii) Security market line – It represents the capital asset pricing model ( CAPM) and helps to derive the expected return of the securities using systematic risk and efficient market hypothesis (EMH). It is derived by the formula :

SML = E(R) =Rf+ β[E(RM)-Rf]

E(R) is the expected return of the security β is the systematic risk of the portfolio

Rm is the

CAPM has a simplified calculation which means it’s easy to calculate the possible outcomes. It’s a diversified portfolio which means there’s no unsystematic risk. It uses the dividend discount model for the systematic risk. It uses WACC- weighted average cost of capital fot determination of the financial risk variability.

Weakness of CAPM

• It creates for volatility because the risk free rate is on the short term government securities.

• It’s asymmetric in nature because the return are normally distributed which reflecs the potential shareholders preferences which creates more risks in natures because there’s an assumption the measurement of risk is adequate to the variance of returns.

• There is an assumption that all the shareholders have access to all the information and that they have agreed about all the returns and risks of the