The capital asset pricing model (CAPM) and the security market line (SML) are used to gauge the expected returns of securities given levels of risk. 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 evaluate a security—in terms of whether it offers a favorable return profile against its level of risk—before including the security within a larger portfolio.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a formula that describes the relationship between the systematic risk of a security or a portfolio and expected return. It can also help measure the volatility or beta of a security relative to others and compared to the overall market.
Key Takeaways
- Any investment can be viewed in terms of risks and return.
- The CAPM is a formula that yields expected return.
- Beta is an input into the CAPM and measures the volatility of a security relative to the overall market.
- SML is a graphical depiction of the CAPM and plots risks relative to expected returns.
- A security plotted above the security market line is considered undervalued and one that is below SML is overvalued.
Mathematically, the CAPM formula is the risk-free rate of return added to thebeta of the security or portfolio multiplied by the expected market return minus the risk-free rate of return:
RequiredReturn=RFR+βstock/portfolio×(Rmarket−RFR)where:RFR=Risk-freerateofreturnβstock/portfolio=BetacoefficientforthestockorportfolioRmarket=Returnexpectedfromthemarket
The CAPM formula yields the expected return of the security. The beta of a security measures the systematic risk and its sensitivity relative to changes in the market. A security with a beta of 1.0 has a perfect positive correlation with its market. This indicates that when the market increases or decreases, the security should increase or decrease by the same percentage amount. A security with a beta higher than 1.0 carries greater systematic risk and volatility than the overall market, and a security with a beta less than 1.0, has less systematic risk and volatility than the market.
Security Market Line
The security 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 the expected return and beta, or systematic risk, associated with a security. The expected return of securities is plotted on the y-axis of the graph, and the beta of 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 return of the market and the risk-free rate of return), and it represents the risk-return tradeoff of a security or portfolio.
CAPM, SML, and Valuations
Together, the SML and CAPM formulas are useful in determining if a security being considered for investment offers a reasonable expected return for the amount of risk taken on. If a security’s expected return versus its beta is plotted above the security market line, it is considered undervalued, given the risk-return tradeoff. Conversely, if a security’s expected return versus its systematic risk is plotted below the SML, it is overvalued because the investor would accept a smaller return for the amount of systematic risk associated.
The SML can be used to compare two similar investment securities that have approximately the same return to determine which of the two securities carries the least amount of inherent risk relative to the expected return. It can also compare securities with equal risk to determine if one offers a higher expected return.
While the CAPM and the SML offer important insights and are widely used in equity valuation and comparison, they are not standalone tools. There are additional factors—other than the expected return of an investment over the risk-free rate of return—that should be considered when making investment choices.
