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The Capital Asset Pricing Model (CAPM) was introduced by Jack Treynor (1961,1962), William Sharpe (1964), John

Lintner (1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics. The model is based on the portfolio theory developed by Harry Markowitz. The model emphasises the risk factor in portfolio theory is a combination of two risk, systematic risk and unsystematic risk. The model suggest that a security's return is directly related to its systematic risk, which cannot be neutralised through diversification. The combination of both types of risk is called as total risk. The total variance of return is equal to market related variance of plus company's specific variance. CAPM explains the behaviour of security prices and provides a mechanism whereby investors could assess the impact of a proposed security in such a way that the risk premium or excess returns are proportional to systematic risk, which is indicated by the beta coefficient. The model is used for analysing the risk-return implications of holding securities. CAPM refers to the manner in which securities are valued in line with their anticipated risks and returns. A risk-averse investor prefers to invest in risk-free securities. For a small investor having few securities in his portfolio, the risk is greater. To reduce the unsystematic risk, he must build up well-diversified securities in his portfolio. Assumptions of CAPM 1. All assets in the world are traded. 2. All assets are infinitely divisible. 3. There are only two periods of time in our world. 4. Security distributions are normal, or at least well described by two parameters. 5. Preferences are well described by simple utility functions. 6. Everyone agrees on the inputs to the Mean-STD picture. 7. All investors in the world collectively hold all assets. 8. For every borrower, there is a lender. 9. There is riskless security in the world. 10. All investors borrow and lend at the riskless rate. CAPM Graph, formula and calculations:-

Example:- Suppose an investment is twice as risky as investing in the stock market. The beta is 2, in this example. Suppose the stock market has yielded 11% return in the last fifty years, so the market rate of return is 11%. Suppose the Treasury note which

matures in 10 years currently yields 6%, so the risk-free rate of return is 6%. Using CAPM, the discount rate r is calculated as follows: r = 6% + 2 (11% - 6%) = 6% + 10% = 16% So, 16% should be used as r in the NPV (net present value) calculations. Security market line The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML), which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. Difference Between CML and SML CML stands for Capital Market Line, and SML stands for Security Market Line. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the markets risk and return at a given time. One of the differences between CML and SML, is how the risk factors are measured.

While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML. The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the securitys risk contribution for the portfolio. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios. While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML. Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML. Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks. Well, the Capital Market Line is considered to be superior when measuring the risk factors. Summary: 1. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the markets risk and return at a given time. 2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the SML. 3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios. 4. The Capital Market Line is considered to be superior when measuring the risk factors.

5. Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML. Empirical tests show market anomalies like the size and value effect that cannot be explained by the CAPM and is explained by FamaFrench three-factor model In asset pricing and portfolio management the Fama-French three factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns. Fama and French were professors at the University of Chicago Booth School of Business. The traditional asset pricing model, known formally as the Capital Asset Pricing Model, CAPM, uses only one variable, beta, to describe the returns of a portfolio or stock with the returns of the market as a whole. In contrast, the FamaFrench model uses three variables. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-to-market ratio (BtM, customarily called value stocks, contrasted with growth stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes:

Here r is the portfolio's expected rate of return, is the risk-free return rate, and is the return of the whole stock market. The "three factor" is analogous to the classical but not equal to it, since there are now two additional factors to do some of the work. stands for "small (market capitalization) minus big" and for "high (book-to-market ratio) minus low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. These factors are calculated with combinations of portfolios composed by ranked stocks (BtM ranking, Cap ranking) and available historical market data. Moreover, once SMB and HML are defined, the corresponding coefficients and are determined by linear regressions and can take negative values as well as positive values. The Fama-French three factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM. The signs of the coefficients suggested that small cap and value portfolios have higher expected returnsand arguably higher expected riskthan those of large cap and growth portfolios