Tuesday, September 16, 2008


What the heck is Capital Asset pricing Model? In my simplest understanding, it is the measure of the rate of return per risk taken. Which do you choose? Option A: You can get a 40% return for a certain amount of risk taken. Option B: You can get 20% return for the same amount of risk taken. Answer: Any rational [one of the assumptions of CAPM model :) ]person would choose option A over option B. The CAPM allows you to represent this. The per risk taken is the risk free return (Rm - Rf). For actual market risk (beta=1), the expected return is the market return.

But what if the expected return of an investment is more than the market return for the same market risk? Will you go for it? Of course, you should. The point of this investment in the CAPM graph will be above the security market line(SML). The SML is the line depicting the expected market return for every value of market risk (If the risk is less than the actual market risk, beta is less than 1 and greater than 0. if the actual risk is more than the actual market risk, then beta is greater than 1. And yes, beta can be negative when the asset price varies inversely wrt the market movement).

If an investment is below the SML, it means that the investment is not worth the risk taken and it is possible to invest in the market itself and get a better return for the same risk. One of the disadvantages of CAPM is that it measures standard deviation as a measure of risk. There are better ways to measure risks like the coherent risk measure.

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