2.2 Capital Asset Pricing Model-CAPM: background of the theory; assumptions; beta estimation – beta coefficient of an individual asset and that of a portfolio and the interpretation of the result; security market line (SML) model and its applications; conceptual differences between portfolio theory and capital asset pricing model; shortcomings of the CAPM

The Capital Asset Pricing Model (CAPM) is a financial model that helps investors and analysts estimate the expected return on an investment based on its risk and the overall market’s risk. It was developed by William Sharpe in the 1960s and has become a widely used tool in finance.

The key components of the CAPM are as follows:

1. Risk-Free Rate: The CAPM starts with the assumption that there is a risk-free rate of return, typically represented by government bonds or treasury bills. This rate represents the return an investor would expect to receive with no risk.
2. Market Risk Premium: The market risk premium is the additional return an investor expects to earn for taking on the risk of investing in the overall market. It is calculated as the difference between the expected return on the market portfolio and the risk-free rate.
3. Beta: Beta is a measure of an investment’s sensitivity to market movements. It quantifies the relationship between the returns of the investment and the returns of the overall market. A beta of 1 indicates that the investment’s returns move in line with the market, while a beta greater than 1 suggests that the investment is more volatile than the market, and a beta less than 1 indicates that the investment is less volatile than the market.
4. Expected Return: The expected return on an investment is calculated using the risk-free rate, the market risk premium, and the investment’s beta. The formula for the expected return in the CAPM is as follows:Expected Return = Risk-Free Rate + Beta * Market Risk Premium