Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr.

Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

Lecture 25
CAPM: A General Equilibrium Theory Of Asset Pricing
We can call this discussion “from CML to SML” , or derivation of CAPM (Capital Asset Pricing Model).
Capital Asset Pricing Model (CAPM) is a theory of asset prices which tells us whether current price of an
asset is its equilibrium price (theoretical correct price, that is fair value, or justified value, or innate
value), or is it undervalued or over valued at its current price. Capital Market Line (CML) is again
shown below; and it is the efficient frontier when risk free lending and borrowing is allowed .

Capital Market Line,

CML. This line is efficient
Rp
frontier
M

Rf

SDp
Since CML is a straight line emerging from Rf and touching Markowitz’s efficient frontier at M,
therefore it is quantified with the equation for straight line which is
Equation for straight line: Y = A + (B * X)

Equation for CML:

expected Rp of efficient portfolio = Rf + [(Rm- Rf)/SDm] * SDp
Rp is Y, the dependent variable, Rf is A, that is intercept of straight line with y-axis; (Rm - Rf) / SDm
is B, the slope of straight line, and SDp is X, the independent variable in this straight line.
This line is usable to find expected R p of only efficient portfolios when risk free lending and borrowing is
allowed. This is so because, as proven earlier, all portfolios on the CML are efficient portfolios.
Regardless of different risk preferences of individual investor, all investors would invest some funds in
the same Markowitz risky portfolio, that is, the tangency portfolio “M”. And each investor would build
her own OPTIMAL PORTFOLIO by investing some fraction of her funds (OE) in the same risky
portfolio “M” and some fraction of funds in risk free asset, such as t-bills. We also proved that this
tangency portfolio has to be the market portfolio. This is called the separation theorem. It say that risk

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

preference of individual investors has been separated from the choice of Markowitz risky portfolio they
hold. So without knowing the risk preference of investors, we know that every investor should invest
some funds in only one Markowitz risky portfolio, and that is portfolio “M”; but the percentage invested
in M and Rf would be different for each investor according to her risk preference. Those investors who
like to take less risk would invest a smaller proportion of their OE in “M” and a bigger proportion in Rf;
while those investors who like to earn high returns and are willing to take more risk would invest a bigger
proportion of their OE in “M” and a smaller or even negative proportion of their OE in Rf.

From CML to SML:

CML refers to Capital Market Line, and SML refers to Security Market Line. We know that according to
Sharpe:

total risk of portfolio = non diversifiable risk + diversifiable risk

and it is written as:

VAR p = B2p VARm + VARep.

VARep is diversifiable risk and it is zero for all the portfolios made by investing in M and Rf, and all
such portfolios fall on CML as we learnt in the previous lecture, So
VARp = B2p VARm + VAR e P
VARp = B p VARm
2
+ 0
This is true for portfolios on CML, that is efficient portfolios when risk free lending and borrowing is
allowed.
If we take under root of both sides, then

SDp = √ B2p VARm + 0

SDp = Bp * SDm
But we know statistically Bp = COV p,m / VAR m.
And COV p,m = CORR p,m * SDp * SD m
So: Bp = (CORR p,m * SDp * SD m )/ VAR m. VAR m = SDm * SDm , so we can write
= (CORR p,m * SDp * SD m )/( SD m * SD m ). SDm cancel SDm, and we are left with
= (CORR p,m * SDp )/( SD m )
And we saw above that
SDp = Bp * SDm
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

entering the expression for beta of portfolio we get:

SD P = {(CORR p,m * SDp )/( SD m )} * SD m.
As SDm cancels out, we are left with
SDp = CORR p,m * SDp . For example if SDp is 4 the equation hold only if Corr =1
4 = 1 *4
This is an interesting result. According to this expression SDp would be equal to SDp only if there is
perfect correlation between returns of market and returns of portfolio P, i.e., CORR p,m is 1. If CORR of
a portfolio P with the market portfolio is perfect , that is 1, then CML is useable to estimate R p because
equations 1 and 2 below would give the same Rp
CML : Rp = Rf + [(Rm –Rf)/SDm] * SDp …..………………………. 1
Rp = Rf + [(Rm –Rf)/SDm] * CORR p,m * SDp …………… 2
But if CORR between a return of portfolio P and return of market portfolio M is not perfect then CML
becomes
Rp = Rf + [(Rm –Rf)/SDm] * CORR p,m * SDp ………………………..3
And you would need to insert a value for correlation to solve for R p of such a portfolio.
But we know that CORR p,m = [COV p,m /(SDp * SDm)]. Inserting this expression of correlation in equation
3 we get
Rp= Rf + [(Rm - Rf)/SDm] * [(COV p,m/(SDp*SDm)] *SDp. SDp cancels out, and we are left with
Rp = Rf + [(Rm - Rf)/SDm] * [COV p,m / SDm]. shuffle the terms
Rp =Rf + (Rm – Rf)* COV p,m/(SDm * SDm )
But we know COV p,m / (SDm * SDm ) = COV p,m / (VARm) = Bp, So equation 3 becomes

Rp = Rf + (Rm – Rf)* Bp. This is derivation of CAPM

Rp = Rf + (Rm – Rf)* Bp is equation of another straight line called SML, Security Market Line

SML
Rm
M
Rf “M” is market portfolio, its beta, Bm ,
is always 1, its ROR is Rm

BRf =0 Bm = 1
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

Bp

The equation given above is called CAPM (Capital Asset Pricing Model). When put on graph , it is
called security market line (SML). It applies to any risky asset, that is, shares of companies as well as
portfolios , efficient portfolios and inefficient portfolios, shares as well as bonds or any other asset such as
plots, currencies, jewels, project, paintings, etc, because it does not require perfect correlation between
the returns of that asset of interest and returns on market portfolio as was required for using CML to

estimate return or risk; and therefore CAPM is a general theory about risk and return

whereas CML was a particular theory about risk and return applicable
to only the efficient portfolios.

SML can be drawn as a straight line because Rf is intercept of straight line, (R m – Rf) is slope of straight
line,
Note: Actually slope of this straight line is Rise = Rm – Rf; and Run is Bm - B Rf. So Slope is
(Rm – Rf)/ (Bm – B Rf). But Bm is 1 by definition and B Rf is zero by definition, so both need not be
written, and slope of SML is written as Rm - Rf
Bp is independent variable, and Rp is dependent variable. When you insert different values of B p , you can
get various values for Rp while Rf and Rm are provided to you by society, as these are macro-economic
variables and their value is same for all investors in a given country at a given point in time.

You can still build efficient portfolios by dividing your OE between investment in a risk free
security (RF t-bills) and investment in market portfolio M. A portfolio built in this manner will fall
exactly on SML because every point on SML is a portfolio made up by dividing the fund in this
manner. Such portfolios also fall exactly on CML.
Every point on SML is a portfolio made up by investing in market portfolio M and risk free t-bills ; and
remember that portfolios built in this manner are always efficient when risk free lending and borrowing is
allowed in a country as proven by the previous discussion on CML. To build a portfolio that falls
somewhere between Rf and M on SML, you invest a portion of your OE in risk free t-bill and the
remaining portion in Market portfolio “M” and X of Rf and X om are positive. To build a portfolio that
falls on the right side of M on SML, you would short sell Rf asset and invest your wealth plus funds
raised by short selling Rf in “M” resulting in Xm being greater than one and X RF being negative

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

To build CML you need two points on the graph paper.

Point 1) is Rf and SD RF ; but SDRF is zero by definition and Rf is known as yield on one year maturity t-
bills; which is available in news papers.
Point 2) is Rm and SDm. So you need to estimate both Rm and SDm .
There are many options or alternatives ways to estimate R m for next year :
1. To estimate Rm read chapter number 7 & 8 from Reilly’s book.
2. Another way to estimate Rm is to use average Rm of past years. Note: for practical purposes a
stock index such as KSE-100 index or SBP all share price index is used as proxy for market
portfolio; and expected percentage change during next year in such an index is used as proxy for
expected Rm. For example: If KSE – 100 index was at 100 on January 1, 2017; and 120 on
December 31, 2017, then Rm for 2017 was (120 -100) / 100 = 20%.
3. Another method of estimating Rm for the next year is: Rm = expected real GDP growth rate +
Inflation risk premium + equity risk premium + political risk premium + currency risk premium.
Using this method in practice may be problematic as estimating these risk premiums is not easy.
4. Another method is to use average PE ratio of the stock market and multiply it by expected
cumulative corporate earnings (that is sum of the expected NI of all companies) to get an
estimate of ending market capitalization (MC), beginning MC is already available from the data;
and then you can estimate Rm as:
Expected Rm = (Ending MC - Beginning MC) / Beginning MC
To calculate SDm for next year you can use data of Rm of past years (past R m’s ) to calculate historical
SDm. Usually for calculating SD m you use 60 monthly observation of R m, that is data for last 5 years.
Resulting SDm is monthly SDm; then multiply it by under root of 12 to make it annual SD m, so that both
Rm and SDm are annualized.
To build SML again you need 2 points on graph paper:
point 1) Rf and B Rf
point 2) Rm and Bm.
As Rf is known from news papers as yield on one year maturity t-bills, and B Rf is zero by definition ,
and Bm is always 1 for any market; therefore you need to estimate only R m as discussed above. Therefore
in terms of data input needed to build CML and SML, SML requires estimations of fewer inputs to
construct the line.

Please note : although the slope of SML = Rise / Run = (R m – Rf) / (Bm – BRf) but it is written as: (R m –
Rf) in CAPM equation because Bm is 1 by definition and BRf is zero by definition therefore both are not

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

written. Intercept of SML with y-axis is Rf, Independent variable in SML is Beta of that asset; while
dependent variable is rate of return on that asset. Here the word asset is used deliberately because SML is
a generally applicable theory of risk and return; and it is applicable to any kind of assets: financial or real;
any kind of portfolio: efficient or inefficient; and any kind of securities: stock or bond.
This generalizability feature of CAPM is the result of not assuming perfect correlation of that asset’s
returns with the market returns; whereas CML is restricted in its application because it assumes perfect
correlation between portfolio’s returns and market returns. Since such perfect correlations are present
only in the efficient portfolios build by dividing proportion of your OE between investment in market
portfolio and risk free t-bills, therefore CML is applicable to estimate risk-return relationship of only such
efficient portfolios, but SML is applicable to all sorts of portfolios as well as to stand alone securities and
real assets.

Why CAPM is Called a Pricing Model

Now you can calculate risk adjusted ROR of any asset by using CAPM equation as long as you knoe beta
of that asset and rf and (Rm – Rf): be it a security such as stock or bond, or an efficient portfolio or
inefficient portfolio, or any real asset such as plot of land, classical painting, a commercial plaza , or a
residential house, a piece of jewelry, etc. To apply CAPM to estimate risk adjusted or risk based rate of
return of an asset, you need know the beta of that asset , Rf and R m in the country , and you can estimate
risk adjusted return of that asset. Or if you know target Return and Rm and Rf then you can estimate its
beta, the relevant risk.

Since in this course we are focused on equity shares and equity portfolios, therefore let us apply this
model of risk – return relationship (CAPM) to shares of corporations.

For shares, risk adjusted required ROR is calculated by using CAPM equation and expected ROR is
calculated by using dividend yield plus capital gains yield for a stock. Then these 2 RORs are compared.
If expected ROR is equal to risk adjusted ROR then expected ROR also falls on SML. In such cases the
asset is said to be rightly priced; and its current price in the market , P o , is said to be its equilibrium
price. But if a share (or portfolio) is mispriced in the market, then its expected ROR won’t fall on SML.
It would fall either above or below SML; its expected ROR would be higher or lower than its risk-
adjusted required ROR as estimated using CAPM.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

Therefore ROR on SML are called required ROR based on Beta Risk or risk adjusted return, and is
calculated from CAPM equation while expected ROR of shares are based on P o, P1 and DPS1. If
expected ROR is not equal to required ROR , then the stock is mispriced.
Similarly expected ROR of portfolio is estimated as ∑Xi*Ri
But risk adjusted required Rp is estimated using CAPM equation
For example:
Expected ROR UBL= (P1 - Po)/Po + ( DPS1/Po)
Required ROR UBL= Rf + (Rm – Rf)*Beta UBL
If Po is too high , Expected ROR is low and this expected ROR lies below SML. So security is
overpriced if its expected ROR is less than the ROR required on SML for that beta risk. If P o is too low
expected ROR would be too high and it lies above SML. So security is underpriced if its expected ROR
is more than the required ROR from CAPM.
Why CAPM is General Equilibrium Pricing Theory of Asset Prices
Please note that CAPM { Ri = Rf + (Rm – Rf ) Bi} , as represented by SML is termed as a general
equilibrium theory of asset prices. It is a general theory because it gives a quantitative relationship
between risk (relevant risk, beta, to be precise) and return of not only efficient portfolios whose
correlation is perfect with the market but also it gives risk-return relationship for inefficient portfolios,
individual stocks, bonds, currencies, and physical assets whose correlation of returns may not be perfect
with the market returns. It is an equilibrium theory of asset prices because it lets us say something
about the current market price (Po) of an asset. It allows us to say whether the asset is undervalued or
overvalued at its current market price; because when required returns and expected returns are equal then
the current Po is the equilibrium price, if that is not the case then Po is not the equilibrium price of that
asset.

We solve for the equilibrium Po of a share by inserting values of DPS 1, P1, Rf, Rm, and Beta. For a
portfolio expected Rp is ∑ xiRi whereas each Ri is expected ROR of a stock and it is estimated as
expected dividend yield plus capital gains yield; and risk adjusted Rp is calculated using CAPM.

For example
Rf is 5% , expected R m is 20%, Beta of ICI is 1.2, expected DPS 1 of ICI is 3 Rs, and expected P 1 is 100
and it is currently trading in the market at 90 rupees; then what is the equilibrium price of ICI ? it is also
called fair value of ICI share or right price for the ICI share or intrinsic value of ICI share or justified

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

price of ICI. We know at equilibrium Po, the expected ROR of ICI should be same as its required ROR
from CAPM, so we solve for fair or justified P0 as shown below:
Expected return = risk adjusted required return from CAPM
DPS1/ Po + (P1 – Po)/Po = Rf + (Rm – Rf) βICI
3/Po + (100 – Po)/ Po = 0.0 5 + (0.20 – 0.05)1.2
(103 - Po)/Po = 0.23
103 – Po = 0.23*Po
103 = 0.23Po + Po
103 = 1.23Po
103/1.23 = Po
83.73 = Po
So 83.73 is equilibrium Po for ICI. As currently ICI is trading in the stock market at 90 Rs, then you
would conclude that at 90 Rs it is overpriced in the market by 6.27 Rs = (90 - 83.73); and in your
opinion its Po should fall soon by 6.27 Rs. This is the context in which CAPM is termed as a general
equilibrium theory of asset pricing. From the decision making point of view, you would not buy ICI at
90 Rs and wait for its price to fall to 83.73. If you already have ICI share then you would sell it now
before its price falls to 83.7 Rs. And if you do not have ICI and you still want to make profit by getting
involved with ICI then you would short sell it at 90 hoping that its price would fall to 83.73 and at that
time you would buy it.

Since different security analysts would estimate Beta, DPS 1, P1, (Rm – Rf) differently, therefore it is
possible that some analysts might be concluding that ICI is overvalued at 90 Rs whereas other analysts
might be viewing it as undervalued at 90 rupees ; and to their respective clients they would be
accordingly giving “sell” and “buy” advice for ICI share.
Exercise
This theory, CAPM says return on any asset depends on its relevant risk, and relevant risk is beta of that
asset. For example if RM is expected to be 20% next year as percentage change in KSE-100 index, and 1-
year maturity t-bills of govt are giving return of 12%, then what would be risk adjusted required rate of
return percentage on:

1. MCB stock whose beta is 1.2

2. Index mutual fund whose beta is 1
3. UBL stock whose beta is 0.8
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

4. t-bills whose beta is zero

Answers
1. R Mcb = Rf + (Rm - Rf) Beta MCB = 12 + (20 - 12)*1.2 = 21.6%
2. R Index fund = Rf + (Rm - Rf) Beta Index Fund = 12 + (20 - 12)*1 = 20%
3. R UBL = Rf + (Rm - Rf) Beta UBL = 12 + (20 - 12)*0.8 = 18.4%
4. R t-bills = Rf + (Rm - Rf) Beta t-bills = 12 + (20 - 12)*0 = 12%
You saw as relevant risk decreases so does expected ROR. So risk and return are directly related
according to CAPM theory . Also note that any asset whose beta is same as market beta, that is 1, its risk
adjusted required return is same as RM. And any asset whose beta is zero, it risk adjusted required return is
same as return on a risk free asset.
So this theory says there is no way to earn higher rate of return and becoming wealthy except by taking
more risk, and risk here means relevant risk, that is beta of that asset. And that is true for investment in all
classes of assets such as shares, bonds, portfolio of shares, portfolio of bonds, balanced portfolios of
shares and bonds, currencies, gold, antiques, plots in DHA, plazas, home, paintings, jewels, agri-land,
housing colonies, efficient portfolios, inefficient portfolios, etc,

An Interesting Exercise To Show the Simplification of Investment Decisions According to Portfolio

Theory
The following estimates of 3 data items are provided for the next year:
Rf =7% (yield on one-year maturity t-bills) ,
expected Rm =20% (expected %age change in a stock index such as KSE-100 Index) ,
SDm=4%.
Risk free lending by purchasing t-bills and risk free borrowing by short selling t-bills is allowed.
Using these 3 data items, please build an efficient portfolio which is expected to give Rp of 250% per
year; and answer the following questions about this portfolio.
Find:
1. X’s of this portfolio (which securities you would include in this portfolio and what proportion of
your OE you would invest in each of those securities to build this efficient portfolio?)
2. Relevant risk , Bp , of this portfolio using SML equation
3. Total risk , SDp , of this portfolio using CML equation
4. Total risk of portfolio, VARp and SDp using Markowitz formula; and check it is same as you got
from CML in item 3 above
5. Find the non diversifiable risk of this portfolio.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

6. Find the diversifiable risk of this portfolio.

7. Is it a well diversified portfolio?
8. Is it an efficient portfolio ?
9. Find R2 coefficient of determination as a measure of %age of non-diversifiable risk in total risk ?
10. Find its CORR p,m
11. Find BP using BP =∑XiBi and see if it is same as estimated in part 2 by using SML (that is CAPM)
12. If you have Rs 20,000 , how much of that you would invest in M and in Rf to build this portfolio
a) Your Rupee profits after one year expected from investment in M and from investment in Rf asset
and consequently total expected profit in Rs after 1 year
b) Show that your expected Rp after one year is = Profits/your Investment (OE) , and it is 250%
13. Does this portfolio fall on CML , on SML ?
14. Is this portfolio at its equilibrium price or mispriced in the market?
15. Market risk premium or market price of risk from CML
16. Market risk premium or market price of risk from SML
17. Slope of CML
18. Slope of SML
19. Risk premium of portfolio or reward for risk taking from CML
20. Risk premium of portfolio or reward for risk taking from SML
21. Reward for waiting from CML
22. Reward for waiting from SML
23. Show Rp from CML = reward for waiting + reward for risk taking
24. Show Rp from SML = reward for waiting + reward for risk taking

Solution:
1. ∑ xiRi = Rp = XmRm + XRF RRF
Rp = XmRm + (1- Xm )RRF Please remember (Xm + XRF = 1, so in place of XRf you can write 1-Xm)
250 =Xm 20 + (1 - Xm )7
250 = 20Xm+ 7 - 7Xm
243= 13Xm
243/13= Xm
18.69 = Xm
XRf = 1 - Xm
XRf = 1 – 18.69

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

XRf = -17.69, and sum of Xs = X m + X RF = 18.69 + -17.69 = 1

2. SML is written as an equation as follows, equation is called CAPM
Rp = Rf + (Rm - Rf)Bp
250=7 + (20 - 7)Bp
250 -7=13Bp
243/13=Bp
Bp = 18.69 (please note Bp is same as Xm)

3. CML is written as equation as given below

Rp = Rf + [(Rm - Rf) /SDm ] * SDp
250 =7 + [ (20 - 7)/4] *SDp
250 - 7= [13/4] SDp
243*4/13 =SDp
74.76% = SDp
(74.76)2 = VARp
5589.05 %2 = VARp

4. VARp=∑Xi2 VAR i ∑∑XiXj COV I,j (I not j) (Markowtiz).

VARp= Xm2 VAR m + XRF2 VARRF + 2(XmXRf COV m,RF )
VARp= (18.69)2(16) + -17.69*0 + 2(18.69 * -17.69 * 0 )
VARp=5589.05% 2

SDp= √5589.05%
SDp= 74.76%
please note it is same as found above from CML in item 3.

5 and 6. Total Risk=Non diversifiable risk + Diversifiable Risk

VARp = B2p VARm + VARep (SDm was 4, so VARm = SDm squared = 16)
5589 = (18.69) (4) +
2 2
VARep .
5589 = 5589 + 0
Non diversifiable risk of this portfolio is B2p VARm=5589%2. Please note that whole of the total risk
is non-diversifiable risk, and diversifiable risk is zero so it is a fully diversified portfolio.
Diversifiable risk =VARep=0 .

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

7. Yes it is a well diversified portfolio as its diversifiable risk, VAR e P = 0. Portfolios built in this
manner fall exactly on SML and CML, therefore such portfolios are always fully diversified.
Please note that all portfolios built by dividing your OE between these 2
securities, that is, investing some OE in risk free security, RF, and some in
market portfolio “M” always have zero diversifiable risk as you saw in this
case. It means such efficient portfolios are always fully diversified; all their
risk is non diversifiable risk. It means their ratio of non diversifiable risk to
total risk is always one, or in other words their R2 is always one.

8. It is an efficient portfolio. This is so because it lies on CML because all portfolios built by
dividing your OE between M and risk free asset lie on CML, and all portfolios that lie on CML
are efficient portfolios. You can check by inserting in CML equation its Rp, Rm, SDm and
calculate its SDp and it would be same as you found above using Markowitz formula.
9. Co-efficient of determination , R2of this portfolio = non diversifiable risk / total risk
5589/5589 = 1, so 100% of its total risk is non diversifiable. 100% of variations in return of this
portfolio are explained by (or crudely speaking you can say are caused by) variations in Rm
10. CORR p,m = √R2= √12 =1. Its Rp is perfectly correlated with the Rm of stock market; and that is
true for all portfolios built by investing in M & Rf. So when risk free lending and borrowing is
allowed then efficient portfolios built by investing in M and Rf always have perfect correlation of
their return with the returns of market portfolio; and their co-efficient of determination is always
1.
11. Bp=∑XiBi
=(Xm* Bm) + (XRF* BRF)
(18.69*1 ) + (-17.69*0)
Bp=18.69
It is the same answer as it is in part 1 using CAPM, also note its beta is same as its Xm; and that
is true for all portfolios built by investing in M & Rf.
12. Rupee Investment in M / OE =Xm
Investment in M = Xm *OE
investment in M= 18.69*20,000 = Rs 373,800
Rupee Investment in risk free asset / OE =XRf
Investment in risk free asset / 20,000 = -17.69
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

Investment in risk free asset = -17.69*20,000

Investment in risk free asset = -353,800 Rs, note minus sign means borrowing so much amount
by short selling the risk free t-bills
Expected Profit on M after 1 year = Investment in “M” * expected R M
= 373,800* 0.2
=Rs 74,760
Expected Profit on Rf after 1 year=Investment in RF*RRF
= -353,800*0.07
Rs – 24,766
Total profit after 1 year= 74,760 - 24,766 = 49,994 , it should come 50,000, the difference is due
to rounding
Expected Rp = ROE = Profit/initial Investment(your equity)
=Rs (50,000/Rs 20,000)* 100 = 250%
13. Yes it does fall on SML because it was built by investing in “M” and Rf; and all dots on SML are
portfolios built in this manner. Note all dots on CML are also portfolios built in this manner so
this portfolio also falls on CML; and that is why we earlier used SML and CML equations for
certain risk and return calculations related to this portfolio in this exercise.
14. It is a rightly priced portfolio, because its expected Rp is equal to its risk adjusted required Rp as
found by using CAPM equation.
Let us find its expected Rp using Markowitz formula
Expected Rp = Xm Rm + X Rf R Rf
= 18.69*20% + -17.69 * 7%
= 250%
Now let us find its risk adjusted (based on risk) Required Rp using CAPM formula
Risk Adjusted Required Rp = Rf + (Rm - Rf) Bp
=7 + (20 - 7) 18.69 = 250%
If expected Rp calculated as Rp = ∑ Xi Ri were different from its required Rp calculated as
Rp = Rf + (Rm - Rf)Bp then it would have been mispriced. But all portfolios built by investing
in M and Rf always have this property that they are rightly priced, that is, they are neither
under priced nor overpriced. Their Rp calculated from sum XiRi and from CAPM is same.
15. Market price of risk or market risk premium from CML = (Rm – Rf) /SDm =( 20 - 7)/4= 3.35
16. Market price of risk or market risk premium from SML = (Rm – Rf ) = ( 20 – 7) = 13
17. Slope of CML = ( Rm – Rf) /SDm =( 20 - 7)/4= 3.35

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

18. Slope of SML = (Rm – Rf ) = ( 20 – 7) = 13

19. Risk premium of this portfolio or reward for risk taking from CML
= ( Rm – Rf) /SDm * SDp = 3.35 * 74.76 = 243
20. Risk premium of this portfolio or reward for risk taking from SML
= (Rm - Rf) * Beta = 13 * 18.69 = 243
21. Price of waiting or reward for waiting from CML = Rf = 7
22. Price of waiting or reward for waiting from SML = Rf = 7
23. Rp from CML = Reward for waiting + reward for risk taking = 7 + 243 = 250
24. Rp from SML = Reward for waiting + reward for risk taking = 7 + 243 = 250

Please note: All portfolios built by investing a fraction of your OE in the market portfolio” M” and
a fraction in risk free t- bills have the following properties
1. Their Bp = Xm
2. They lie on CML because all points on CML are achieved by investing in M and Rf
3. The portfolios built by investing in M and RF are efficient portfolios because they lie on CML,
and CML is efficient frontier in the presence of risk free lending and borrowing. When risk free asset
(for example t-bills) is present in a country and investors can do risk free lending by investing in t-
bills and also can do risk free borrowing by shorting the t-bills then in such situation Markowitz
efficient curve is no more efficient frontier; rather the straight line called CML is the efficient frontier.
The portfolios built by investing in M and RF lie on SML so they are neither undervalued or over
valued at their current Po , that means their expected returns calculated as: R p =∑XiRi ; and their
risk adjusted required returns calculated by CAPM as: R p = (Rf + (Rm – Rf)Bp are equal.
4. They have 0 diversifiable risk (VAR e P), that means, they are fully diversified, and their VAR e p

is zero
5. Their R2 =1 that is all their risk is non diversifiable risk, and 100% variations in their returns are
due to variations in market return
6. Their returns are perfectly correlated with market returns, that is: CORR p,m=1
The following table gives comparison of CML and SML

CML: Risk & return relationship of SML: Risk & return relationship of any asset
only efficient portfolios is linear, as is linear as given below
given below

Y= intercept + Slope * X Y= Intercept + Slope * X

Rp = Rf + [(Rm –Rf)/SDm] * SDp . It Says Ri = Rf + (Rm – Rf)*Bi . It Says that expected

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2022. Instructor: Dr. Sohail Zafar.
TA: Ms Maheen Chaudhry and Ms Roha Asim

that expected return of an efficient return of any asset depend upon its relevant risk
portfolio depends upon it total risk. i.e., beta.
Efficient portfolios means those built by
investing your OE in M and Rf.

Slope of the above straight line is Slope of the above straight line is market price
Market Price of risk , also termed as of risk , also termed as market risk premium or
market risk premium or excess return excess market return per unit of relevant risk or
per unit of total market risk (Rm – per unit of beta. But because beta of market is
Rf)/SDm, only SDm is written in one and Beta of Rf is zero, both are not written
denominator instead of SDm – in denominator; so slope of SML is written as
SD Rf because SD RF is zero by definition. (Rm – Rf) instead of

Rm – Rf)/SDm is also called Market (Rm – Rf)/(Bm – B Rf)

price of risk from CML, or market risk
premium, or excess market return per Rm – Rf) is also called Market price of risk
unit of total risk of market from SML, or market risk premium, or
excess market return per unit of relevant
market risk or excess market return when beta
is market beta, that is one

Intercept is price of waiting or reward Intercept is price of waiting, or reward for

for waiting or time value of money, its waiting , or time value of money, its Risk free
Risk free rate earned by investing in t- rate earned by investing in t-bills.
bills

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