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Advanced Financial Management · Portfolio Management

CAPM and Security Market Line (CA Final AFM)

Updated 5 October 2026 · Fact-checked

CAPM says a security's required return equals the risk-free rate plus beta times the market risk premium: Ke = Rf + β(Rm − Rf). Plot this against beta to get the Security Market Line. Compare expected return with required return: above the line means undervalued, below means overvalued.

Understand CAPM and Security Market Line

Investors want a reward for two things: waiting (time value) and bearing risk. The risk-free rate pays for waiting. The extra return pays for risk. CAPM tells you how much extra return is fair.

CAPM only rewards systematic risk, the part of risk you cannot remove by diversification. Company-specific risk can be diversified away, so the market does not pay you for it. Beta (β) measures systematic risk: how much a security moves when the market moves. The market has β = 1. A security with β = 1.5 tends to move 1.5 times as much as the market.

The market risk premium is (Rm − Rf), the extra return the market gives over the risk-free rate. Multiply it by beta and add Rf. The answer is the required return.

The Security Market Line (SML) draws this relationship: beta on the x-axis, required return on the y-axis. The intercept is Rf and the slope is (Rm − Rf). It applies to individual securities and to portfolios. A security whose expected return plots above the line gives more than its risk demands, so it is undervalued (buy). One below the line is overvalued (sell or avoid).

Do not confuse the SML with the Capital Market Line (CML). The CML plots return against total risk (standard deviation) and covers only efficient portfolios. The SML plots return against beta and covers every security and portfolio.

Key rules to remember

CAPM required return
E(Ri) = Rf + βi × (Rm − Rf)
Rm − Rf is the market risk premium. Use the result as the required return (cost of equity).
Beta of a security
β = Cov(i, m) ÷ σm² = ρim × σi ÷ σm
Cov is covariance with the market; σm² is market variance. ρim is the correlation coefficient.
Beta of a portfolio
βp = Σ(wi × βi)
Weights are market-value proportions and must add up to 1. Include the risk-free asset with β = 0.
Security Market Line
Required return = Rf + slope × β, where slope = (Rm − Rf)
Intercept is Rf. Straight line with beta on the x-axis.
Capital Market Line
E(Rp) = Rf + [(Rm − Rf) ÷ σm] × σp
Uses total risk σp. Applies only to efficient portfolios.
Alpha / valuation test
Alpha = Expected return − Required return
Alpha > 0: undervalued. Alpha < 0: overvalued. Alpha = 0: fairly priced.
Total risk split
σ² = β² × σm² + unsystematic variance
Systematic variance is β²σm². Only this part is priced by CAPM.

How to solve CAPM and Security Market Line questions

Use this sequence for any CAPM or SML question. It works for single securities, portfolios and valuation questions.

  1. 1List the data: Rf, Rm (or market premium), betas, weights, expected returns, and any covariance, correlation or standard deviations.
  2. 2If beta is not given, calculate it as Cov(i, m) ÷ σm², or as ρ × σi ÷ σm. Check that you are dividing by market variance, not standard deviation, when you use covariance.
  3. 3If a portfolio is involved, compute portfolio beta as the weighted average of betas. Treat the risk-free asset as beta 0.
  4. 4Compute the required return: Rf + β × (Rm − Rf). If Rm is given, subtract Rf first. If the premium is given, use it directly.
  5. 5Compare the expected return (or the market-based return) with the required return for each security.
  6. 6Decide: expected > required means undervalued (buy); expected < required means overvalued (sell); equal means fairly priced.
  7. 7If asked for intrinsic value, discount the expected cash flows at the required return, or use the price-return link: required return = (D1 + P1 − P0) ÷ P0.
  8. 8State the conclusion in one line and mention the SML position (above, below or on the line).

Quickest way: Required return first, then compare

When to use it: Use it for multi-security valuation tables where you must classify each security as overvalued or undervalued within a few minutes.

  1. Compute the market premium (Rm − Rf) once and keep it on the side.
  2. For each security, calculate Rf + β × premium in one line.
  3. Write expected return beside it and the difference (alpha) with its sign.
  4. Mark the sign: plus means undervalued, minus means overvalued.
  5. For portfolio beta, multiply weight by beta only for each holding and add. Do not recompute returns unless asked.

Common mistakes in CAPM and Security Market Line

  • Using Rm instead of (Rm − Rf) as the multiplier of beta.

    Students recall 'Rf + β × market return' from memory and drop the subtraction.

    Fix: Always write the premium (Rm − Rf) as a separate line before multiplying by beta.

  • Dividing covariance by market standard deviation to get beta.

    Variance and standard deviation both appear in the data and get mixed up.

    Fix: Beta = Cov(i, m) ÷ σm². If only standard deviations and correlation are given, use ρ × σi ÷ σm.

  • Calling a security overvalued when its expected return is above the SML.

    Students think a high return means a high price.

    Fix: Higher expected return for the same risk means the price is too low today, so the security is undervalued. Below the line means overvalued.

  • Treating the CML and SML as the same line.

    Both start at Rf and both slope upward.

    Fix: CML: total risk (σ) on the x-axis, efficient portfolios only. SML: beta on the x-axis, all securities and portfolios.

  • Leaving out the risk-free asset when finding portfolio beta, or using weights that do not sum to 1.

    Students focus only on the risky securities listed in the table.

    Fix: Include every holding. Risk-free has beta 0. Check that weights total 1 before multiplying.

  • Assuming a high-beta stock is always a good buy or a bad buy.

    Beta is mistaken for a measure of quality or return.

    Fix: Beta only measures systematic risk. Judge the stock by comparing expected return with the required return.

Worked examples

Example 1

The risk-free rate is 7% and the expected market return is 13%. Three securities have the following data: A (β 0.8, expected return 11%), B (β 1.2, expected return 13%), C (β 1.5, expected return 17%). Using CAPM, state whether each is undervalued or overvalued.

Show the solution
  1. Market premium = 13% − 7% = 6%.
  2. A: required = 7% + 0.8 × 6% = 7% + 4.8% = 11.8%. Expected 11% < 11.8%, alpha = −0.8%.
  3. B: required = 7% + 1.2 × 6% = 7% + 7.2% = 14.2%. Expected 13% < 14.2%, alpha = −1.2%.
  4. C: required = 7% + 1.5 × 6% = 7% + 9% = 16%. Expected 17% > 16%, alpha = +1%.

Answer: A and B plot below the SML and are overvalued. C plots above the SML and is undervalued.

Example 2

An investor holds ₹4,00,000 in Stock P (β 1.4), ₹3,00,000 in Stock Q (β 0.9) and ₹3,00,000 in government securities treated as risk-free. Rf is 6% and the market return is 12%. Find the portfolio beta and its required return. If the portfolio's expected return is 10.5%, is it fairly priced?

Show the solution
  1. Total value = ₹10,00,000. Weights: P 0.4, Q 0.3, risk-free 0.3.
  2. Portfolio beta = 0.4 × 1.4 + 0.3 × 0.9 + 0.3 × 0 = 0.56 + 0.27 + 0 = 0.83.
  3. Market premium = 12% − 6% = 6%.
  4. Required return = 6% + 0.83 × 6% = 6% + 4.98% = 10.98%.
  5. Expected 10.5% < required 10.98%, alpha = −0.48%.

Answer: Portfolio beta is 0.83 and the required return is 10.98%. Since the expected return of 10.5% is lower, the portfolio is below the SML and is overvalued, so it is not fairly priced.

Exam tips

  • Show the market premium as a separate line. Examiners award marks for method even if arithmetic slips.
  • In beta questions, read carefully whether you are given variance or standard deviation of the market, and whether covariance or correlation is supplied.
  • Always end valuation questions with a clear verdict: overvalued or undervalued, with the SML position and the alpha.
  • For theory questions on CML versus SML, write a two-column comparison: x-axis, applicability, risk measure, and what lies on the line.
  • In case-scenario MCQs, estimate quickly: required return = Rf + β × premium. Eliminate options that ignore Rf or use Rm directly.

Practice questions from Portfolio Management

CAPM and Security Market Line in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CAPM and Security Market Line: frequently asked questions

What is the difference between the Capital Market Line and the Security Market Line?

The CML plots expected return against total risk (standard deviation) and applies only to efficient portfolios. The SML plots required return against beta and applies to all securities and portfolios. Under CAPM, a security is priced fairly when it lies on the SML.

How do I calculate the beta of a portfolio?

Multiply each holding's beta by its weight (market value share) and add the results. Include the risk-free asset with beta zero. The weights must sum to 1.

How do I know whether a security is overvalued or undervalued under CAPM?

Compute its required return using CAPM and compare it with the expected return. If expected is higher, the security is undervalued. If expected is lower, it is overvalued.

Can beta be negative?

Yes. A negative beta means the security tends to move opposite to the market. Under CAPM its required return will be below the risk-free rate, because it reduces the risk of a diversified portfolio.