Lesson 7 of 7 · All lessons in this module
  1. The risk-free asset, the market portfolio and the CMLVideo lesson
  2. Lending, borrowing and leveraged portfolios on the CMLVideo lesson
  3. Systematic and nonsystematic riskVideo lesson
  4. Return-generating models, the market model and betaVideo lesson
  5. The CAPM: assumptions, the SML and its limitsVideo lesson
  6. Sharpe ratio, Treynor ratio, M² and Jensen's alphaVideo lesson
  7. Applying the CAPM: budgeting, security selection and portfolio buildingVideo lesson

Lesson 7 of 7 · 14 min

Applying the CAPM: budgeting, security selection and portfolio building

The CAPM gives the required return for projects and assets; comparing your own return forecast with that required return (alpha) tells you what to buy, sell and how much to hold.

In short

  • The CAPM return is the usual first estimate of the required return for valuing assets and for capital budgeting (discount rate in NPV), also for regulated companies' cost of capital and fair insurance premiums.
  • The security characteristic line (SCL) plots Ri−RfR_i - R_f against Rm−RfR_m - R_f: intercept = Jensen's alpha, slope = beta.
  • With heterogeneous beliefs, a forecast return above the SML (positive alpha) means undervalued: buy. Below the SML means overvalued: avoid or short.
  • Add securities with positive alpha, drop or underweight those with negative alpha. Weight each in proportion to αi/σei2\alpha_i/\sigma_{e_i}^2: more alpha, more weight; more nonsystematic risk, less weight.
  • The information ratio αi/σei\alpha_i/\sigma_{e_i} is abnormal return per unit of nonsystematic risk added. About 30 randomly chosen securities remove most nonsystematic risk.

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