Capital Asset Pricing Model ( CAPM) Assignment Help, CAPM Homework Help/CAPM
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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, ̅ra = rf + βa (̅ rm - rf) ,
where rf is the risk free rate, βa is the Beta of the security, ̅rm 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 (̅ rm - rf).
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
Es = rf + Bs(Emkt - rf), where Es is the expected return of the investment, rf is the risk free rate, Bs is the Beta of
the investment and Emkt is the expected market return .
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