Series 7

Portfolio Management - Capital Asset Pricing Theory

This leads into the subject of the capital asset pricing model (CAPM), sometimes called the capital asset pricing theory (or CAPT), which derives the anticipated rates of return on assets based on the assets' risk levels. These rates of return fall along a curve known as the security market line (SML).

Risk-free Rate of Return
As you know, an investment's reward ought to be equal to its risk. However, the risk/reward relationship is not quite so straightforward.

For example, there is a reward for investing in a T-bill - let's say it is a 3% return; a T-bill is a short-term instrument, so if risk really equals return, does that mean there is a 3% chance the U.S. government will go out of business in the next 180 days? Of course not. The benefit that comes from holding an essentially bulletproof investment is called the risk-free rate of return (RFR).

Basically, RFR is the risk in the background. No, Uncle Sam probably is not going anywhere, but the market risk described in Section 2 still exists. That is the baseline from which you will measure the risk, and thus the expected return, inherent in a particular security.

For the purposes of this discussion, let's set the RFR at 3%. Every investment out there that is not risk-free will have an expected return over 3%. The riskier the investment, the higher a return it will have to offer to attract investors. The market as a whole is comprised of a myriad of investment options, some riskier than others. If you were to buy every security in the world, you would have a portfolio filled with investments across the risk spectrum, and thus across the yield spectrum. For present purposes, let's say the market as a whole yields 15%.



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