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Introduction to CAPM and its relation with Capital Market Line and Security Market Line By Muhammad Mobeen Ajmal

Welcome to this introductory session on the Capital Asset Pricing Model (CAPM), a widely used finance model that establishes a linear relationship between the required return on investment and risk. In this video, we'll discuss how CAPM is used to price risky securities and assets, its relation to the Capital Market Line (CML) and Security Market Line (SML), and the interpretation of beta.

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money, while the other components of the formula account for the investor taking on additional risk. The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market.

If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio. The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared with its expected return. By knowing the individual parts of the CAPM, it is possible to gauge whether the current price of a stock is consistent with its likely return.

The Capital Market Line (CML) represents portfolios that optimally combine total risk and return. It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. The portfolios with the best trade-off between expected returns and variance (risk) lie on this line. The tangency point between the efficient frontier and the Capital Market line is the optimal portfolio of risky assets, known as the market portfolio. Theoretically, a market portfolio is a hypothetical collection of investments that encompasses all available assets in the investment universe, with each asset being weighted based on its overall representation in the market. The expected return of a market portfolio is equal to the expected return of the overall market.

The Security Market Line (SML) is a graphical representation of the CAPM formula. It shows the relationship between the expected return and beta of an asset, given the risk-free rate and the market risk premium. The slope of the SML represents the market risk premium, which is the return expected from the market above the risk-free rate.

Understanding the interpretation of beta is essential in determining an investment's risk profile. Beta measures the sensitivity of an asset's returns to changes in the market portfolio. A beta greater than one indicates that the asset is riskier than the market, while a beta less than one indicates that the asset is less risky than the market. A negative beta implies that the asset moves in the opposite direction to the market.

In conclusion, the Capital Asset Pricing Model (CAPM) is a useful tool for investors to evaluate the risk and return of an investment, and the Capital Market Line (CML) and Security Market Line (SML) can help investors understand how to optimally allocate their portfolios. The interpretation of beta is also essential in determining an investment's risk profile. With this knowledge, investors can make informed decisions on their investments and manage their portfolio risk effectively.