The Financial Asset Valuation Model (CAPM) and Securities Market Line (SML) are used to assess expected returns of securities based on risk levels. The concepts were introduced in the early 1960s and built on earlier work on diversification and modern portfolio theory.Investors sometimes use CAPM and SML to value a security (in terms of whether it offers a favorable return profile relative to its level of risk) before including the security in a larger portfolio.
Financial asset valuation model
The Asset Valuation Model (CAPM) is a formula that describes the relationship between the systematic risk of a security or portfolio and the expected return. It can also help measure the volatility or beta of a security relative to others and relative to the overall market.
Key points to remember
- Any investment can be viewed in terms of risk and return.
- The CAPM is a formula that gives the expected return.
- Beta is an entry into the CAPM and measures the volatility of a security relative to the overall market.
- SML is a graphical representation of the CAPM and plots risks against expected returns.
- A security drawn above the securities market line is considered undervalued and a security below SML is overvalued.
Mathematically, the CAPM formula is the risk-free rate of return added to the beta of the security or portfolio multiplied by the expected market return minus the risk-free rate of return:
Return required=RFR+??stock / portfolioÃ(RMarlet–RFR)or:RFR=Risk-free rate of return??stock / portfolio=Beta coefficient for the stock or portfolioRMarlet=Expected market return
The CAPM formula gives the expected return on the security. The beta of a security measures the systematic risk and its sensitivity to changes in the market. A stock with a beta of 1.0 has a perfect positive correlation with its market. This indicates that when the market rises or falls, the stock should rise or fall by the same percentage. A security with a beta greater than 1.0 carries greater systematic risk and volatility than the overall market, and a security with a beta less than 1.0 carries lower systematic risk and volatility than the market.
Security Market Line
The Securities Market Line (SML) displays the expected return of a security or portfolio. It is a graphical representation of the CAPM formula and plots the relationship between expected return and the beta, or systematic risk, associated with a security. The expected return of the securities is plotted on the y-axis of the chart and the beta of the securities is plotted on the x-axis. The slope of the relationship plotted is known as the market risk premium (the difference between the expected market return and the risk-free rate of return) and it represents the risk-return trade-off of a security or an asset. wallet.
CAPM, SML and valuations
Together, the SML and CAPM formulas are useful in determining whether a security considered for investment offers a reasonable expected return for the amount of risk taken. If a security’s expected return relative to its beta is plotted above the securities market line, it is considered undervalued, given the risk-return tradeoff. Conversely, if the expected return of a security relative to its systematic risk is plotted below the SML, it is overvalued because the investor would accept a lower return for the amount of associated systematic risk.
The SML can be used to compare two similar investment securities that have approximately the same return to determine which of the two securities has the least inherent risk compared to the expected return. It can also compare securities of equal risk to determine if a higher expected return is offered.
Although the CAPM and SML offer important information and are widely used in the evaluation and comparison of stocks, they are not stand-alone tools. Other factors, other than the expected return on an investment relative to the risk-free rate of return, should be taken into account when making investment choices.