Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

(^468) © The McGraw−Hill
Companies, 2002
This result is the famous capital asset pricing model (CAPM).^3
What the CAPM shows is that the expected return for a particular asset depends on
three things:
1.The pure time value of money.As measured by the risk-free rate, Rf, this is the
reward for merely waiting for your money, without taking any risk.
2.The reward for bearing systematic risk.As measured by the market risk premium,
E(RM)
Rf, this component is the reward the market offers for bearing an average
amount of systematic risk in addition to waiting.
3.The amount of systematic risk.As measured by (^) i, this is the amount of systematic
risk present in a particular asset or portfolio, relative to that in an average asset.
By the way, the CAPM works for portfolios of assets just as it does for individual assets.
In an earlier section, we saw how to calculate a portfolio’s. To find the expected re-
turn on a portfolio, we simply use this in the CAPM equation.
Figure 13.4 summarizes our discussion of the SML and the CAPM. As before, we
plot expected return against beta. Now we recognize that, based on the CAPM, the slope
of the SML is equal to the market risk premium, E(RM)
Rf.
440 PART FIVE Risk and Return
capital asset pricing
model (CAPM)
The equation of the SML
showing the relationship
between expected return
and beta.
(^3) Our discussion leading up to the CAPM is actually much more closely related to a more recently developed
theory known as the arbitrage pricing theory (APT). The theory underlying the CAPM is a great deal more
complex than we have indicated here, and the CAPM has a number of other implications that go beyond the
scope of this discussion. As we present it here, the CAPM has essentially identical implications to those of
the APT, so we don’t distinguish between them.

FIGURE 13.4

The Security Market

Line (SML)

Asset

expected

return (E(Ri))

Rf

The slope of the security market line is equal to the market risk premium; i.e.,

the reward for bearing an average amount of systematic risk. The equation

describing the SML can be written:

E(Ri) = Rf  (^) i  [ E(RM)
Rf]
which is the capital asset pricing model (CAPM).
E(RM)
= E(RM)
Rf
(^) M = 1.0
Asset
beta i