Assumptions of the CAPM
The assumptions of the CAPM include:
Capital market theory builds on portfolio theory. CAPM refers to the capital asset pricing model. It is used to determine the required rate of return for any risky asset.
In the discussion about the Markowitz efficient frontier, the assumptions are:
The CAPM uses the SML or security market line to compare the relationship between risk and return. Unlike the CML, which uses standard deviation as a risk measure on the X axis, the SML uses the market beta, or the relationship between a security and the marketplace.
The use of beta enables an investor to compare the relationship between a single security and the market return rather than a single security with each and every other security (as Markowitz did). Consequently, the risk added to a market portfolio (or a fully diversified set of securities) should be reflected in the security's beta. The expected return for a security in a fully diversified portfolio should be:
E(RM) - Rf is the market risk premium, while the risk premium of the security is calculated by β[E(RM) - Rf].
Note that the "expected" and the "required" returns mean the same thing. The expected return based on the CAPM is exactly the return an investor requires on the security.
The SML represents the required rate of return, given the systematic risk provided by the security. If the expected rate of return exceeds this amount, then the security provides an investment opportunity for the investor. The difference between the expected and required return is called the alpha (α) or excess rate of return. The alpha can be positive when a stock is undervalued (it lies above the SML) or negative when the stock is overvalued (it falls below the SML). The alpha becomes zero when the stock falls directly on the SML (properly valued).
Security Market Line vs. Capital Market Line:
Portfolio Beta. The β of a portfolio is the weighted sum of the individual asset betas. For example, if 40% of the money is in stock A with a β of 2.0 and 60% of the money is in stock B with a β of 0.8, the portfolio β is 0.4 x 2.0 + 0.6 x 0.8 = 1.28.
|teddajr: Very Important Topic for review.|
|Farina: Yeah, these premises are the cornerstone of most successful value investing strategy. Rumour has it that the trigger for a Buffet/Berkshire Hathaway purchas is an SML undervaluation of 40%, which would explain why they have such strong long term returns.|
|gazza77: i think they've written the formula wrong in the first paragraph says Cov(m,m)= var(m)???? obviously Cov(m,m)=1?|
|soorajiyer: Well explained, thanks!|
|cfatime21: Great summary at the bottom...|
| Naoual: @Gazza|
substituate i by m, and you get:
Cov(m,m)=1xSTmxSTm=Var(m) 1 is the correlation.
|gill15: Agree with CFAtime. Amazing summary at end. I would`ve spent a couple hours wasting time figuring out what the differences were without that.|
|Corey678: Expected Return(stock) equation very similar to BDY minus the time aspect.|