The Capital Asset Pricing Model (CAPM) is a model that describes the

relationship between the expected return and risk of investing in a security. It

shows that the expected return on a security is equal to the risk-free return
plus a risk premium, which is based on the beta of that security. Below is an
illustration of the CAPM concept.

CAPM Formula and Calculation

CAPM is calculated according to the following formula:

 
 

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Beta 

The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk
(volatility of returns) reflected by measuring the fluctuation of its price
changes relative to the overall market. In other words, it is the stock’s
sensitivity to market risk. For instance, if a company’s beta is equal to 1.5 the
security has 150% of the volatility of the market average. However, if the beta
is equal to 1, the expected return on a security is equal to the average market
return.  A beta of -1 means security has a perfect negative correlation with the
market.

Risk-Free Rate 

The “Rrf” notation is for the risk-free rate, which is typically equal to the yield
on a 10-year US government bond.  The risk-free rate should correspond to
the country where the investment is being made, and the maturity of the bond
should match the time horizon of the investment. Professional convention,
however, is to typically use the 10-year rate no matter what, because it’s the
most heavily quoted and most liquid bond.

Expected Return 

The “Ra” notation above represents the expected return of a capital asset over
time, given all of the other variables in the equation.  “Expected return” is a
long-term assumption about how an investment will play out over its entire
life.

Market Risk Premium

From the above components of CAPM, we can simplify the formula to reduce
“expected return of the market minus the risk-free rate” to be simply the
“market risk premium”.  The market risk premium represents the additional
return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put another way, the
more volatile a market or an asset class is, the higher the market risk premium
will be.

Why CAPM is Important

The CAPM formula is widely used in the finance industry. It is vital in

calculating the weighted average cost of capital (WACC) as CAPM computes
the cost of equity.

WACC is used extensively in financial modeling.  It can be used to find the net
present value (NPV) of the future cash flows of an investment and to further
calculate its enterprise value and finally its equity value.

CAPM Example – Calculation of Expected Return

Let’s calculate the expected return on a stock, using the Capital Asset Pricing
Model (CAPM) formula. Suppose the following information about a stock is
known:

 It trades on the NYSE and its operations are based in the United States
 Current yield on a U.S. 10-year treasury is 2.5%
 The average excess historical annual return for U.S. stocks is 7.5%
 The beta of the stock is 1.25 (meaning it’s average weekly return is 1.25x
as volatile as the S&P500 over the last 2 years)

What is the expected return of the security using the CAPM formula?
Let’s break down the answer using the formula from above in the article:

 Expected return = Risk Free Rate + [Beta x Market Return Premium]

 Expected return = 2.5% + [1.25 x 7.5%]
 Expected return = 11.9%

Grab a calculator and let's use the CAPM. If the risk-free rate (as

reflected by Company X returns) is 0.10, the average market
return (as indicated by the 1-year return on Company Z) is 20.63,
and Pear Products has a beta coefficient of 0.74, the appropriate
required return for Pear Products (rounded to two decimal
places) is.

Question: Suppose the market premium is 9%, market volatility is 30% and the risk-free rate is
3%. (a) What is the equation of the SML? (b) Suppose a security has a beta of 0.6. According to
the CAPM, what is its expected return? (c) A security has a volatility of 60% and a correlation
with the market portfolio of 25%. According to the CAPM, what is its expected return? (d) A
security has a volatility of 80% and a correlation with the market portfolio of -25%. According to
the CAPM, what is its expected return?
Question: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Suppose rf = 2% and Rm =
12%. (a) According to the CAPM, what are the expected returns for each stock?
Question: Suppose you estimate that stock A has a volatility of 32% and a beta of 1.42, whereas
stock B has a volatility of 68% and a beta of 0.75. (a) Which stock has more total risk? (b)
Which stock has more market risk? (c) Suppose the risk-free rate is 2% and you estimate the
market’s expected return as 10%. Which firm has a higher cost of equity capital?

Question: Suppose you group all stocks into two mutually exclusive portfolios of growth or
value stocks. Suppose the growth stock portfolio and value stock portfolio have equal size in
terms of total value. Furthermore, suppose that the expected return of the value stocks is 13%
with a volatility of 12%, whereas the expected return of the growth stocks is 17% with a
volatility of 25%. The correlation of the returns of these two portfolios is 0.50. The risk-free rate
is 2%. (a) What is the expected return and volatility of the market portfolio (which is a 50-50
combination of the two portfolios)? (b) Does CAPM hold in this economy?
The tangency point between the capital market line and the indifference curve is the optimal
portfolio for a particular investor.
The tangency point is the optimal portfolio of risky assets, known as the market portfolio. ...
Less risk averse investors will prefer portfolios higher up on the CML, with a higher expected
return, but more variance
CML vs SML

CML stands for Capital Market Line, and SML stands for Security
Market Line.

The CML is a line that is used to show the rates of return, which
depends on risk-free rates of return and levels of risk for a specific
portfolio. SML, which is also called a Characteristic Line, is a
graphical representation of the market’s risk and return at a given
time.
One of the differences between CML and SML, is how the risk
factors are measured. While standard deviation is the measure of
risk for CML, Beta coefficient determines the risk factors of the
SML.
The CML measures the risk through standard deviation, or
through a total risk factor. On the other hand, the SML measures
the risk through beta, which helps to find the security’s risk
contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios,
the Security Market Line graphs define both efficient and non-
efficient portfolios.

While calculating the returns, the expected return of the portfolio

for CML is shown along the Y- axis. On the contrary, for SML, the
return of the securities is shown along the Y-axis. The standard
deviation of the portfolio is shown along the X-axis for CML,
whereas, the Beta of security is shown along the X-axis for SML.

Where the market portfolio and risk free assets are determined by
the CML, all security factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows
the expected returns of individual assets. The CML determines the
risk or return for efficient portfolios, and the SML demonstrates
the risk or return for individual stocks.

Well, the Capital Market Line is considered to be superior when

measuring the risk factors.

Summary:

1. The CML is a line that is used to show the rates of return, which
depends on risk-free rates of return and levels of risk for a specific
portfolio. SML, which is also called a Characteristic Line, is a
 graphical representation of the market’s risk and return at a given
time.

2. While standard deviation is the measure of risk in CML, Beta

coefficient determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient portfolios,

the Security Market Line graphs define both efficient and non-
efficient portfolios.

4. The Capital Market Line is considered to be superior when

measuring the risk factors.

5. Where the market portfolio and risk free assets are determined
by the CML, all security factors are determined by the SML.

One major difference is thay CML have both systematic and

unsystamatic risk but SML have only systematic risk.
The differences between the capital market line and the security market line:

Capital market line:

 CML shows the tradeoff between expected return and total risk.
 CML considers both systematic and unsystematic risk.
 CML is the graphical presentation of the equilibrium relationship between
expected return and total risk for efficiency diversified portfolios.
 The slope of the CML shows the market price of risk for efficient portfolios.
 The CML is a line that is used to show the rates of return, which depends
on risk-free rates of return and levels of risk for a specific portfolio.
 Slope of the CML = (Rm – Rf) / σm

Security market line:

 SML shows the tradeoff between the required rate of return and systematic
risk.
 SML considers only systematic risk.
 SML is the graphical presentation of CAPM.
 The slope of the SML shows the differences between the required rate of
return on the market index and the risk-free rate.
 SML is a graphical representation of the market’s risk and returns at a
given time.
 The slope of the SML = (Rm – Rf).

Read more: Difference Between CML and SML | Difference

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