FIN 614: Financial Management
Larry Schrenk, Instructor
1. Capital Market Line (CML)
2. Security Market Line (SML)
3. Capital Asset Pricing Model (CAPM)
Return
Market Portfolio
rf
Efficient Frontier
CML
MVP
sp
Security Market Line (SML)
Graphing the relationship between beta and
return
Begin with the two points we know:
Market
Risk Free Asset
Return
rM
rf
Beta
1
0
Return
We know two points.
Where would we find portfolios that contain
combinations of the risk free asset and the
market?
rM
Market
rf
Risk Free Asset
0
1
Beta
SML
Return
What would happen if there were a
stock above the line?
Market equilibrium forces all stocks to be on the
line, which is called the Security Market Line
(SML).
rM
What would happen if
there were a stock below
the line?
rf
0
1
Beta
CAPM Equation
Formula for the SML
E  ri   rf   i  rM  rf 
E ri  = Expected Return on Stock i; rf = Risk-Free Rate
βi = Beta of Stock i; rM = Return on the Market
Firm Data
Beta
Market Data
The Risk Free Rate
The Return on the Market
It is the equilibrium model that underlies
all modern financial theory.
Derived using principles of diversification
with simplified assumptions.
Markowitz, Sharpe, Lintner and Mossin
are researchers credited with its
development.
Single-period investment horizon.
Investors forecasts agree with respect
to expectations, standard deviations,
and correlations of the returns of risky
securities
Therefore all investors hold risky assets in
the same relative proportions
Investors behave optimally
In equilibrium, prices adjust so that
aggregate demand for each security is
equal to its supply
Beta
Linear Regression
Firm Stock Return on Market Return (S&P 500)
Risk Free Rate
Treasury Security
Maturity = CAPM Time Horizon
Return on the Market
Average Return on a Market Portfolio (S&P
500)
Use the following, to find the expected
return:
rf = 4.5%
rM = 12.3%
Find the expected return on the following
three stocks:
• A = 1.02
• B = 0.89
• C = 1.34
E  ri   rf   i  rM  rf 
E  rA   0.045  1.02  0.123  0.045   12.46%
E  rB   0.045  0.89  0.123  0.045   11.44%
E  rC   0.045  1.34  0.123  0.045   14.95%
FIN 614: Financial Management
Larry Schrenk, Instructor