Capital Asset Pricing Model - CAPM

What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The other half of
the formula represents risk and calculates the amount of compensation the investor needs for taking
on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model - CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security
plus a risk premium. If this expected return does not meet or beat the required return, then the investment
should not be undertaken. The security market line plots the results of the CAPM for all different risks
(betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in
this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected
market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
Capital Market Line - CML
What Does Capital Market Line - CML Mean?
A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios
depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.

Investopedia explains Capital Market Line - CML

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point
where the expected return equals the risk-free rate of return. 

The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a
risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market
portfolio is essentially the efficient frontier. This is achieved visually through the security market line
(SML).
Security Market Line - SML
What Does Security Market Line - SML Mean?
A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and
shows all risky marketable securities.

Also refered to as the "characteristic line".

Investopedia explains Security Market Line - SML
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 security market line is a useful tool in determining whether 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 risk versus expected return is plotted above the SML, it is undervalued because the investor
can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because
the investor would be accepting less return for the amount of risk assumed.

Characteristic Line
What Does Characteristic Line Mean?
A line formed using regression analysis that summarizes a particular security or portfolio's systematic risk
and rate of return. The rate of return is dependent on the standard deviation of the asset's returns and the
slope of the characteristic line, which is represented by the asset's beta.

Investopedia explains Characteristic Line

A characteristic line of a stock is the same as the security market line, and is very useful when employing
the capital asset pricing model, or when using modern portfolio formation techniques. The slope of the
line, which is a measure of systematic risk, determines the risk-return tradeoff. According to this metric,
the more risk you take on - as measured by variability in returns - the higher the returns you can expect to
earn.

There is considerable controversy regarding the use of beta as a measure of risk and return.

Efficient Frontier
What Does Efficient Frontier Mean?
A line created from the risk-reward graph, comprised of optimal portfolios. 
Investopedia explains Efficient Frontier
The optimal portfolios plotted along the curve have the highest expected return possible for the given
amount of risk.

Beta
What Does Beta Mean?
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a
whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected
return of an asset based on its beta and expected market returns..

Also known as "beta coefficient".

Investopedia explains Beta
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's
returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with
the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of
greater than 1 indicates that the security's price will be more volatile than the market. For example, if a
stock's beta is 1.2, it's theoretically 20% more volatile than the market. 

Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a
beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
Alpha
What Does Alpha Mean?
1. A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual
fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund
relative to the return of the benchmark index is a fund's alpha.

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an
equilibrium model like the capital asset pricing model (CAPM).
Investopedia explains Alpha
1. Alpha is one of five technical risk ratios; the others are beta, standard deviation, R-squared, and the
Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these
indicators are intended to help investors determine the risk-reward profile of a mutual fund. Simply stated,
alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a
fund's return.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a
similar negative alpha would indicate an underperformance of 1%.

2. If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the
portfolio actually earns 15%, the portfolio's alpha would be 5%. This 5% is the excess return over what
was predicted in the CAPM model.

Modern Portfolio Theory - MPT

What Does Modern Portfolio Theory - MPT Mean?
A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return
based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Also called "portfolio theory" or "portfolio management theory."

Investopedia explains Modern Portfolio Theory - MPT

According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the
maximum possible expected return for a given level of risk. This theory was pioneered by Harry
Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. 

There are four basic steps involved in portfolio construction:

-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measurement
Markowitz Efficient Set
What Does Markowitz Efficient Set Mean?
A set of portfolios with returns that are maximized for a given level of risk based on mean-variance
portfolio construction. The efficient "solution set" to a given set of mean-variance parameters (a given
riskless asset and a given risky basket of assets) can be graphed into what is called the Markowitz
efficient frontier.
Investopedia explains Markowitz Efficient Set
The Markowitz efficient set is all of the portfolios on the efficient frontier, or those that generate the largest
return for a given risk level. The mean-variance and subsequent efficient set theory at one time
revolutionized portfolio management, and remains a core lecture in any economist's university years. The
theory of mean-variance portfolios lead to the capital asset pricing model, and is still a vital component of
professional money management today.
Risk
What Does Risk Mean?
The chance that an investment's actual return will be different than expected. This includes the possibility
of losing some or all of the original investment. Risk is usually measured by calculating the standard
deviation of the historical returns or average returns of a specific investment. 

Many companies now allocate large amounts of money and time in developing risk management
strategies to help manage risks associated with their business and investment dealings. A key component
of the risk mangement process is risk assessment, which involves the determination of the
risks surrounding a business or investment. 

Investopedia explains Risk
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk
that an investor is willing to take on, the greater the potential return. The reason for this is that investors
need to be compensated for taking on additional risk. 

For example, a U.S. Treasury bond is considered to be one of the safest investments and, when
compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is
much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate
bond is higher, investors are offered a higher rate of return.
Systematic Risk
What Does Systematic Risk Mean?
The risk inherent to the entire market or entire market segment. 

Also known as "un-diversifiable risk" or "market risk."

Investopedia explains Systematic Risk

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire
market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of
securities, unsystematic risk affects a very specific group of securities or an
individual security. Systematic risk can be mitigated only by being hedged. 

Even a portfolio of well-diversified assets cannot escape all risk. 

Unsystematic Risk
What Does Unsystematic Risk Mean?
Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk
can be reduced through appropriate diversification. 

Also known as "specific risk", "diversifiable risk" or "residual risk".

Investopedia explains Unsystematic Risk

For example, news that is specific to a small number of stocks, such as a sudden strike by the employees
of a company you have shares in, is considered to be unsystematic risk. 
Return
What Does Return Mean?
The gain or loss of a security in a particular period. The return consists of the income and the capital
gains relative on an investment. It is usually quoted as a percentage.

Investopedia explains Return
The general rule is that the more risk you take, the greater the potential for higher return - and loss. 

Return is also used as an abbreviation for income tax return, see 1040 Form.
Risk-Return Tradeoff
What Does Risk-Return Tradeoff Mean?
The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are
associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with
high potential returns. According to the risk-return tradeoff, invested money can render higher profits only
if it is subject to the possibility of being lost. 

Investopedia explains Risk-Return Tradeoff

Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing
investments for your portfolio. Taking on some risk is the price of achieving returns; therefore, if you want
to make money, you can't cut out all risk. The goal instead is to find an appropriate balance - one
that generates some profit, but still allows you to sleep at night.