Mastering CAPM and the Security Market Line | CFA Level I Portfolio Management

Today, we’ll unravel the mysteries of the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML).

A Quick Recap: The Single-Index Model

In our last lesson, we discussed the single-index model, which considers only the excess return on the market as a risk factor. By rearranging the formula, we get the basis of CAPM:

Expected returns of assets = Risk-free rate + Beta × (Expected market return – Risk-free rate)

The CAPM asserts that expected returns of assets vary only by their systematic risk, as measured by beta. Two different assets with the same beta will have the same expected return, regardless of the nature of those assets.

Beta: A Measure of Systematic Risk

Why is beta considered a measure of an asset’s systematic risk? Beta is the sensitivity of an asset’s return to the market’s return. Systematic risk is due to market factors and can be measured by the variance of market returns, while unsystematic risk is due to firm-specific factors. Unsystematic risk can be diversified away for free, so investors shouldn’t expect additional returns for taking it on. This is consistent with CAPM, where only systematic risk determines an asset’s expected returns.

Introducing the Security Market Line (SML)

If we plot the relationship between an asset’s expected return and its systematic risk, we get a straight line called the Security Market Line.

CAPM Assumptions

The CAPM is simple thanks to its assumptions about investors, the market, and investable assets. Some key assumptions include:

• Investors are risk-averse and require higher expected returns for greater risk.
• Investors maximize utility based on their individual preferences.
• All investors have the same one-period time horizon.
• Investors have homogeneous expectations for assets’ returns, standard deviations, and correlations.
• Markets are competitive, with investors as price takers.
• Markets are frictionless, with no taxes, transaction costs, or barriers to trading.
• All investments are infinitely divisible, allowing investors to invest as little or as much as desired.

Security Market Line vs. Capital Market Line

Don’t confuse the Security Market Line with the Capital Market Line (CML)! They may seem similar, but there are key differences:

• The CML uses total risk on the x-axis, while the SML uses only systematic risk.
• Only efficient portfolios plot on the CML, while all properly priced assets and portfolios plot on the SML.

Applications of CAPM and the Security Market Line

Some practical applications of CAPM and the SML include:

• Estimating a firm’s weighted average cost of capital (WACC) during the capital budgeting process.
• Valuing equities using dividend discount models, where the required rate of return is based on the stock’s beta.
• Comparing a stock’s forecasted return to its required return based on beta risk, to determine if it is undervalued or overvalued.

And there you have it! We’ve covered the essentials of CAPM and the Security Market Line. In our next lesson, we’ll discuss ways to evaluate portfolio performance.