![]() ![]() The line itself is called the security market line (or SML), as shown in Figure 1. The formula is that of a straight line, y = a + bx, with βi as the independent variable, Rf as the intercept with the y axis, (E(r m ) – Rf) as the slope of the line, and E(ri) as the values being plotted on the straight line. If shares are being considered, E(rm) is the required return of equity investors, usually referred to as the ‘cost of equity’. This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium – βi (E(rm) – Rf) – which compensates the investor for the systematic risk of the financial asset. The formula for the CAPM, which is included in the formulae sheet, is as follows:Į(ri) = return required on financial assetĮ(rm) = average return on the capital market This minimum level of return is called the ‘risk-free rate of return’. The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk of the investment's return being different from the expected return. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The CAPM assumes that investors hold fully diversified portfolios. The sum of systematic risk and unsystematic risk is called total risk (Watson D and Head A, Corporate Finance: Principles and Practice, 7th edition, Pearson Education Limited, Harlow pp.245-6). The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they have issued. The risk which cannot be eliminated by portfolio diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial system. There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not eliminate risk entirely. By diversifying investments in a portfolio, therefore, an investor can reduce the overall level of risk faced. In fact, it has been found that the risk of the portfolio is less than the average of the risks of the individual investments. ![]() If an investor has a portfolio of investments in the shares of several different companies, it might be thought that the risk of the portfolio would be the average of the risks of the individual investments. The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. Investors take the risk of an investment into account when deciding on the return they wish to receive for making the investment. Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the investment will be different from the expected return. Two further articles will look at applying the CAPM in calculating a project-specific discount rate, and will look at the theory, and the advantages and disadvantages of the CAPM. This article introduces the CAPM and its components, shows how it can be used to estimate the cost of equity, and introduces the asset beta formula. Section E of the Study Guide for Financial Management contains several references to the Capital Asset Pricing Model (CAPM). An introduction to professional insights.Virtual classroom support for learning partners.Becoming an ACCA Approved Learning Partner. ![]()
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