Capital Asset Pricing Model ( CAPM) Assignment Help, CAPM  Homework Help/CAPM Online Tutoring

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About Capital Asset Pricing Model (CAPM)

The relationship between risk and expected return is explained using the Capital Asset Pricing Model (CAPM) developed by William Sharpe (1964) and John Lintner (1965). Based on this model,  ̅r_a = r_f + β_a (̅ r_m - r_f) , where r_f is the risk free rate,   β_a is the  Beta of the security, ̅r_m    is the expected market return  and   ̅ra is the expected return of the security. Thus, CAPM is used in the pricing of risky securities.  There are two methods of compensation for the investors, based on the CAPM, which include the time value of money and the risk. The risk free rate denotes the time value of money and the investors are compensated for the investment of money over a time period through this risk free rate. In the CAPM formula, the compensation for taking additional risk is captured by the second half. This shows the product of the risk measure denoted by the beta measure and the market premium captured as (̅ r_m - r_f). 

According to the CAPM formula, the risk free security rate plus the risk premium is equivalent to the expected return on a security or portfolio. There is no need for the investment in case of the expected return not beating the return needed. The security market line plots the CAPM for various risks. In this graph, the x-axis and y-axis values are respectively the beta and the expected return. The slope of the SML shows the market risk premium. The calculation of the expected values for the security market line is done with the equation

E_s = r_f + B_s(E_mkt - r_f), where E_s is the  expected return of the investment, r_f is the risk free rate, B_s is the Beta of the investment  and   E_mkt is the expected market return .    

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