CAPM model was
developed by Nobel Price winner William Sharpe,
John Lintner, Jack Trainor, and Jan Mossin. It
is based of Capital Market Theory which is an
evolution of Portfolio Theory of Harry Markowitz.
In Capital market theory risk less assets are
added which was not considered in the Portfolio
theory. This addition of risk free asset changes
the Markowitz Efficient Frontier from a curve
into a straight line called Capital market line.
Foundation of Capital market line theory &
CAPM is based on following assumptions:
I. Investors are rational
II. Risk free lending and borrowing
III. Total risk is divided into two types
IV. Homogeneous expectations
V. Same Time Frame.
VI. Divisible Assets
VII. Friction less capital markets
VIII. Perfect competition
CAPM model is based on Capital market line. Only
the systematic risk is rewarding and there will
be no reward for unsystematic risk as it can be
diversified by a balanced portfolio construction.
So if investor invest in a company which has higher
systematic risk then it will get higher return.
This systematic risk is directly proportional
to return.
E( r ) = required return from security
rf = risk free rate
rm = return from the market as a whole
Sm = Systematic risk of market
Investor demand reward for the relevant risk.
That risk always greater then risk free rate.
Different companies have different systematic
risks so investment in more risky company will
give more return but chances of loss are also
high.
The systematic risk is measured by beta (??. It
is a standardized measure of systematic risk.
Beta measures the sensitivity of a security’s
return to changes in the market return.
The Capital market line represents all portfolio
and assumes that all assets lie on the curve.
The straight line is called Security Market Line
(SML). CAPM is derived from the linear equation
of the SML as follows:
E(r) = rf + ???rm – rf) = CAPM
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