Using the Capital Asset Pricing Model, we need to keep three things in mind. 1 there is a basic reward for waiting, the risk free rate. 2 the greater the risk, the greater the expected reward. 3 there is a consisted trade off between risk and reward. In finance, It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk.
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 – a model that calculates the expected return of an asset based on its beta and expected market returns.)
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%)).
Risk of a Portfolio We all know that investments have risk, so it’s safe to assume that all stocks have risk as well? But did you know that there are different types of risk as well? Most people think that all risk is the same but it’s true. There are some risk that you can avoid via diversification and other types of risk that are 100% completely unavoidable meaning you can’t dodge it or rid of it it’s always there. The risk of a portfolio comprises systematic risk, also known as undiversifiable risk and Unsystematic risk is also known as idiosyncratic risk or diversifiable risk.
Systematic risk that is unavoidable. It refers to the risk common to all securities—i.e. market risk. Systematic risk is due to risk factors that affect the entire market such as investment policy, policy changes, foreign investment policy, economic parameter, global security threats and etc. This type of risk is beyond the control of investors (me, you or anybody) and cannot be mitigated to a large extent.
Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks “average out”). Unsystematic risk is due to factors specific to an industry or company like product category, research and development, pricing, market strategy. Etc. This type of risk is unavoidable yet market does compensate investors for taking exposure to such risks. So you see that this risk is completely avoidable. You can avoid the risk by buying different securities that are not related to one another or minimal relation so that’s how you avoid risk.
In portfolio theory, what we talk about here is the fact that the more numbers of securities you have in a portfolio (generally speaking there is a max and that is what you called efficient frontier) the less unsystematic risk you’ll gonna have on that portfolio. And you can see on the unsystematic risk feature here gonna de curse. Risk is measured up and down and there is a certain level of systematic risk which is always present and that is mark here by a to b line.
Systematic risk is always present no matter how many securities we have on portfolio so this is completely unavoidable but for unsystematic risk which is just specific to different companies/industries you can avoid that risk and reduce your risk by diversifying the number of stock you have. So the more you have, the closer you’ll gonna get to pure systematic risk and that’s always a good thing like you’re gonna reduce as much risk in your portfolio as possible.
The essence of CAPM: The more systematic risk you carry, the greater your expected return.
Capital Market Theory Capital Market Theory tries to explain and predict the progression of capital (and sometimes financial) markets over time on the basis of the one or the other mathematical model. Capital market theory is a generic term for the analysis of securities. In terms of trade off between the returns sought by investors and the inherent risks involved, the capital market theory is a model that seeks to price assets, most commonly, shares.
Security market line Vs. CAPM 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. It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. Market Model Vs. CAPM
The market model is a mathematical way of modelling past security price return by regressing them on the return of a market index. The market model is an ex post model, which means it describes past portfolio price behaviour. The CAPM model is an ex ante model, which means it predicts what the portfolio value should be.