Week - Deriving CAPM

Capital Market Line (CML)

1. The graphical representation of CAPM, shows the relationship between the expected return on the efficient portfolio and their total risk

2. Measures the risk through standard deviation, or through a total risk factor

3. Graphs of the CML define the efficient portfolios

4. Y-axis represents expected return

5. X-axis represents the standard deviation or level of risk

2. Security Market Line (SML)

1. The graphical representation of CAPM, shows the relationship between the required return on individual security as a function of systematic, non-diversifiable risk

2. Measures the risk through beta, which helps to find the security’s risk contribution to the portfolio

3. Graphs of the SML define both efficient and non-efficient portfolios

4. Y-axis represents the level of the required return on individual assets

5. X-axis shows the level of risk represented by beta

A movement along the SML

Reflects changes in the perceived risk of a security/ firm

• Change in firm risk (e.g. business/ financial risk) will cause movement along the SML

A change in the Slope of the SML

Reflects changes in the return required by investors per unit of risk

• SML rotates clockwise, about the risk-free rate, when there is a decrease in the risk and vice versa