CAPM was developed in 1960 as an extension of Markowitz's portfolio theory. It derives the relationship between expected return and risk of individual securities. CAPM assumes investment decisions are based on risk-return assessments and that markets are efficient. It allows investors to combine risky and risk-free assets on the efficient frontier to maximize return for a given level of risk. The model is used to price individual securities based on their beta and expected market return.

2. Introduction
 CAPM was developed by William Sharpe, John
Lintner & Jan Mossin in 1960.
 An extension of the portfolio theory of Markowitz.
 It derives the relationship between the expected
return & the risk of individual securities.

3. Assumptions
 Investment decisions are made on the basis of risk-return
assessments.
 Purchases & sales by a single investor cannot affect
prices.
 No transaction cost.
 No personal income taxes.
 Investors share homogeneity of expectation.

4. Efficient frontier with riskless
lending & borrowing
• Investing in a combination of risk free
asset & risky assets
C
B
A
Rf
0
Portfolio risk
(σp)
Portfoli
o
Return
(Rp)

5. Rm RF
Eg:
E(R) 15% 7%
σ 8% -
W 60% 40%
Return
RC= WRm + (1-W) Rf
RC= (0.60) (15) + (0.40)(7)
RC= 11.8 per cent
Risk
σc = wσm
σc =(0.60)(8)= 4.8 per cent

6. Investors funds & the Risky portfolio
If weight is proportion of investors funds invested in
the risky portfolio,
 If w=1, the investors funds are fully committed to the
risky portfolio.
 If w<1, only fraction of the funds is invested in the
risky portfolio & the remainder is lend at the risk free
rate.
 If w>1, the investor is borrowing at the risk free rate &
investing an amount larger than his own funds in the
risky portfolio.

7. Calculation of the Risk & Return in a
levered Portfolio
RL= wRm – (w-1)R f
Where,
RL=return in the levered portfolio
w=the proportion of investor's in the risky portfolio
Rm=return on the risky portfolio
Rf=the risk free borrowing rate
σL = wσm
Assuming w=1.25,
RL= (1.25)(15) – (0.25)(7)
RL= 17 per cent
σL= (1.25)(8) = 10 per cent

8. Efficient frontier with borrowing and
lending
σp
B
0
A
C
RP
Rf
Borrowing
Lending

9. Pricing of securities with CAPM
 CAPM can be used for evaluating the pricing of
security.
Where,
P0= current market price
P1= estimated market price after one year
D1= anticipated dividend for the year

10. CAPM & security valuation
C
R
Q
P
N
M
L
B
A
SML
Estimated
Return
0 0.7 Beta
2.0
0
1.0 1.3
0
Rf

11. Prepared by;
 Shakthi Fernando
BSc. Financial management(Special)-
Undergraduate
Sabaragamuwa University of Sri Lanka
 Biyanka Jayawardhana
BSc. Financial management(Special)-
Undergraduate
Sabaragamuwa University of Sri Lanka

12. Thank You