CAPM (Capital asset pricing model)

An important tool to analyze the relationship between risk and expected

returns on assets (particularly stocks) when they are held in well diversified
portfolios.
The CAPM’s Security Market Line (SML) equation shows the relationship between a security’s market
risk and its required rate of return. The return required for any security i is equal to the risk-free rate
plus the market risk premium times the security’s beta:

r
(a) Risk free rate of return RF (expected return on long-term govt. bonds)

(b) Return on stock market rM

(c) Market risk premium, RPM

RPM = rM- rRF

It is the additional return over the risk free rate required to induce an average investor to invest
in the market Portfolio.

(d) Stocks beta coefficient bi

Beta coefficient

A measure of a stock’s market risk, or the extent to which the returns on a given stock move with the
stock market.

The tendency of a stock to move up and down with the market is reflected in its beta coefficient.
An average-risk stock is defined as one with a beta equal to 1.0. Such a stock's returns tend to move up
and down, on average, with the market, which is measured by some index such as the S&P 500, or the
S&P/TSX Composite Index.

Avg. risk stock beta 1.0 (stocks return tend to move up & down, on average, with the market)

B=0.5 half as risky as the market.

B=2.0 twice as risky as the market.

The S&P/TSX Composite Index is an index of the stock (equity) prices of the 256 largest companies on
the Toronto Stock Exchange (TSX) as measured by market capitalization. The Toronto Stock Exchange
listed companies in this index account for about 70% of market capitalization for all Canadian-based
companies listed on the TSX.