Investments, tenth edition

 Figure 9.2 

The security market line  

E(r)

E(r

M

)

E(r

M

)

2r

f

5Slope of SML

SML

r

f

β

M

51.0

1

β

 Suppose that the risk premium on the market portfolio is estimated at 8% with a standard deviation of 

22%. What is the risk premium on a portfolio invested 25% in Toyota and 75% in Ford, if they have betas 

of 1.10 and 1.25, respectively? 

 CONCEPT CHECK 

9.3 

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  C H A P T E R  

9

  The Capital Asset Pricing Model 

299

fair expected return on a risky asset. Then security 

analysis is performed to calculate the return actually 

expected. (Notice that we depart here from the simple 

CAPM world in that some investors now apply their 

own unique analysis to derive an “input list” that may 

differ from their competitors’.) If a stock is perceived 

to be a good buy, or underpriced, it will provide an 

expected return in excess of the fair return stipulated 

by the SML. Underpriced stocks therefore plot above 

the SML: Given their betas, their expected returns 

are greater than dictated by the CAPM. Overpriced 

stocks plot below the SML.  

 

The difference between the fair and actually 

expected rates of return on a stock is called the stock’s 

   alpha   , denoted by  a . For example, if the market return 

is expected to be 14%, a stock has a beta of 1.2, and the 

T-bill rate is 6%, the SML would predict an expected 

return on the stock of 6  1  1.2(14  2  6)  5  15.6%.  If 

one believed the stock would provide an expected 

return of 17%, the implied alpha would be 1.4% (see 

 Figure 9.3 ).  

 One might say that security analysis (which we 

treat in Part Five) is about uncovering securities with 

nonzero alphas. This analysis suggests that the starting point of portfolio management can 

be a passive market-index portfolio. The portfolio manager will then increase the weights 

of securities with positive alphas and decrease the weights of securities with negative 

alphas. We showed one strategy for adjusting the portfolio weights in such a manner in 

Chapter 8. 

 The CAPM is also useful in capital budgeting decisions. For a firm considering a new 

project, the CAPM can provide the  required rate of return  that the project needs to yield, 

based on its beta, to be acceptable to investors. Managers can use the CAPM to obtain this 

cutoff internal rate of return (IRR), or “hurdle rate” for the project. 

 The nearby box describes how the CAPM can be used in capital budgeting. It also 

discusses some empirical anomalies concerning the model, which we address in detail in 

Chapters  11–13.