Application of Capital Asset Pricing Model Based on the Security Market Line

Abstract

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual security perspective, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market., Securities with higher returns are considered to be undervalued and attractive for buy. The below normal expected return yielding securities are considered to be overvalued and suitable for sale. SML is found to be the best tool for capital asset pricing analysis as it gives that a clear signal of overpriced and underpriced. In this paper we attempt to compare expected return estimates, which are implicit in share prices, growth rates, and the dividend growth model, with expected return estimates from the CAPM. We use the National Stock Exchange as the market benchmark for computing betas for the CAPM, and S&P CNX NIFTY Stocks for computing betas for the CAPM. Our sample comprises S&P CNX NIFTY companies over the period 2005 - 2010.In this paper five years nifty stocks of 10 companies has been taken for testing relevance of CAPM analysis. The main objective of this paper is to test the CAPM model and to use the CAPM for the selection of securities and portfolios using SML.