CAPM & the Security Market Line
The CAPM prices an asset by its systematic risk β: E(R_i) = R_f + β_i·(E(R_m) − R_f). Plotted against β this is the Security Market Line, from R_f at β = 0 through the market at β = 1. An asset above the line is under-valued and one below it is over-valued. The gap is its alpha.
CAPM required return at β = 1.109.6%
Market risk premium E(R_m) − R_f 6.0%
Risk-free rate R_f3.0%
Market return E(R_m)9.0%
Asset beta β1.10
Try this
At β = 1.10 the CAPM requires 9.6%: the risk-free 3.0% plus β times the 6.0% market risk premium. Tick the box above to compare an actual return and read off alpha.
SML vs CML. This is the SML: it uses β and prices every asset, fairly priced or not. The CML uses total risk σ and applies only to efficient portfolios. Same market point, different risk axis.
Discuss: if a stock plots above the SML, what should buying pressure do to its price, and where does the point move as it re-prices?