(rm-rf).Investment is associated with risk and return, which are quantified, and interdependent; less risk less return, and more risk more return. We can graphically display this dependency on risk – return plane using CAPM model. In this model, risk is expressed through a parameter ß, and return through another parameter E (Ri). Algebraic expression of the model is E (Ri) = Rf The straight line represented by the equation E (Ri) = Rf + [E (Rm) – Rf] x ß is called security market line or SML. This straight line illustrates the market risk versus return of the entire market at a certain time (Shapiro). Conceptually the SML equation demonstrates the relationship between expected return and covariance of an asset i. For CAPM equilibrium condition, any asset should appear on the SML. The parameter ß of the equation of i asset is expressed as ßi = σiM/ σ2M = Cov (ri, rM)/ σ2M. It should be noted that σ indicates risk, and σ2 variance in the portfolio theory. Coefficient ß measures systematic risk of the portfolio. The index M in the formula is the efficient market portfolio, whereas the index i indicates a single stock. Thus, the ß expresses relation of covariance of return of a single stock and market portfolio to the variance of the market portfolio. The Portfolio Theory.
INVESTOPEDIA. Market Portfolio. Retrieved from http://www.investopedia.com/terms/m/market-portfolio.asp
Sepand Jazzi. (n.d.). Stock and Portfolio Variance and Standard Deviation [Video]. Retrieved from http://www.youtube.com/watch?v=q69sfKgsxEc
Shapiro, A. (n.d.). Foundations of Finance: The Capital Asset Pricing Model (CAPM). NYUSTERN. Retrieved from http://pages.stern.nyu.edu/~ashapiro/courses/B01.231103/FFL09.pdf
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