THE CAPITAL ASSET PRICING MODEL (CAPM) There are two risky assets, Stock A and Stock B. Now suppose there exists a risk- free asset — an asset which gives.

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THE CAPITAL ASSET PRICING MODEL (CAPM) There are two risky assets, Stock A and Stock B. Now suppose there exists a riskfree asset — an asset which gives an annual interest payment with certainty. You can think of this asset as being a savings account in a bank or a government bond. The addition of a risk-free asset to the portfolio of risk assets leads to four new concepts:

THE CAPITAL ASSET PRICING MODEL (CAPM) 1. The capital market line (CML) is the set of all optimal investment portfolios for an investor. A portfolio on the CML is a combination of the risk-free asset and the risky assets.

THE CAPITAL ASSET PRICING MODEL (CAPM)

2. The market portfolio (denoted by the letter M) is the best portfolio of risky assets available to the investor.

THE CAPITAL ASSET PRICING MODEL (CAPM) 3. The security market line (SML) describes the relation between the expected returns of any asset and the asset ’ s risk.

THE CAPITAL ASSET PRICING MODEL (CAPM) The SML says that the expected return on any portfolio of assets is related to the riskfree rate and the market risk-premium through the following relation:

THE CAPITAL ASSET PRICING MODEL (CAPM)