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CFA Level I Exam · Portfolio Risk and Return: Part II

CAPM and the Security Market Line for CFA Level I

Updated 7 October 2026 · Fact-checked

The Capital Asset Pricing Model says a security's required return equals the risk-free rate plus beta times the market risk premium: E(Ri) = Rf + βi × [E(Rm) − Rf]. Plot it against beta and you get the security market line. Compare your forecast return with the required return to judge value.

Understand Capital Asset Pricing Model and Security Market Line

Investors can remove nonsystematic risk by diversifying. So the market pays them only for systematic risk, the risk that moves with the whole market. CAPM measures that risk with beta.

Beta shows how sensitive a security is to market returns. The market portfolio has a beta of 1. A beta of 1.5 means the security tends to move 1.5 times as much as the market. A beta of 0 means no market sensitivity, which is the case for the risk-free asset.

The required return has two parts: the risk-free rate, which pays you for time, and a risk premium, which pays you for bearing market risk. The risk premium is beta times the market risk premium [E(Rm) − Rf].

The security market line (SML) graphs this equation. Beta is on the x-axis and expected (required) return is on the y-axis. The intercept is Rf and the slope is the market risk premium. Any fairly priced security lies on the line.

To test value, compare your expected return (forecast) with the required return from CAPM. If expected return is above the line, the security offers more than its risk requires, so it is undervalued. If it is below the line, it is overvalued. The difference is called alpha.

Do not confuse the SML with the capital market line (CML). The CML uses total risk (standard deviation) and applies only to efficient portfolios. The SML uses beta and applies to any security or portfolio.

Key formulas to remember

CAPM required return
E(Ri) = Rf + βi × [E(Rm) − Rf]
[E(Rm) − Rf] is the market risk premium. Use decimals or percentages consistently.
Beta
βi = Cov(Ri, Rm) ÷ Var(Rm) = ρ(i,m) × σi ÷ σm
Use whichever inputs the question gives. Remember Cov(Rm, Rm) = Var(Rm), so the market beta is 1.
Portfolio beta
βp = Σ wi × βi
Weights are market-value weights and sum to 1. Beta is a weighted average.
Alpha (Jensen's)
α = expected (or actual) return − CAPM required return
Positive alpha means the security plots above the SML (undervalued). Negative means below (overvalued).
SML
Intercept = Rf; slope = E(Rm) − Rf
x-axis is beta. The SML is a line for all securities, not only efficient portfolios.

How to solve Capital Asset Pricing Model and Security Market Line questions

Use this order for any CAPM or SML question.

  1. 1Write down Rf, the market return or market premium, and beta. Check whether the question gives E(Rm) or the premium E(Rm) − Rf already.
  2. 2If beta is not given, compute it from covariance and market variance, or from correlation and standard deviations. For a portfolio, take the weighted average of betas.
  3. 3Apply E(Ri) = Rf + β × premium. Convert percentages carefully.
  4. 4If the question asks about value, compare your forecast return with the required return.
  5. 5Forecast above required: undervalued, positive alpha, buy. Forecast below: overvalued, negative alpha, sell or avoid.
  6. 6Sanity check: beta above 1 should give a required return above the market return, and beta below 1 should give one below it (when the premium is positive).

Quickest way: Required return in one line

When to use it: Any question that gives Rf, beta and the market return or premium and asks for a return or a value call.

  1. Compute premium = Rm − Rf.
  2. Required = Rf + β × premium, done mentally.
  3. Compare with the forecast. Higher forecast means undervalued.
  4. Eliminate options that are on the wrong side of the market return for the given beta, then check the remaining two.

Common mistakes in Capital Asset Pricing Model and Security Market Line

  • Multiplying beta by the market return instead of the market risk premium

    The formula is remembered loosely as Rf + β × Rm.

    Fix: Always subtract Rf first. Beta multiplies [E(Rm) − Rf].

  • Calling a stock with a high expected return undervalued without comparing to its required return

    A high return looks attractive on its own.

    Fix: Compare with the SML return for that beta. A high-beta stock needs a high return.

  • Using standard deviation instead of beta on the SML

    Mixing up the SML with the CML.

    Fix: SML: beta on the x-axis, any asset. CML: standard deviation, efficient portfolios only.

  • Reading overvalued and undervalued backwards from the SML graph

    The price direction is not intuitive.

    Fix: Above the line means the return is too high for the risk, so the price is too low: undervalued. Below the line means overvalued.

  • Getting portfolio beta by adding betas or using wrong weights

    Weights are forgotten or do not sum to 1, for example when a risk-free asset is held.

    Fix: Use weights that sum to 1 and give the risk-free asset a beta of 0.

  • Treating CAPM as proven fact in assumption questions

    Assumptions are skimmed.

    Fix: Remember the assumptions: investors are risk averse and maximize utility, use mean-variance analysis, share homogeneous expectations, have a single period, can borrow and lend at the risk-free rate, markets are frictionless with no taxes or transaction costs, and all assets are marketable and priced as takers.

Worked examples

Example 1

The risk-free rate is 3%, the expected market return is 9%, and a stock has a beta of 1.4. Which is the stock's required return under CAPM? A. 8.4% B. 11.4% C. 15.6%

Show the solution
  1. Market risk premium = 9% − 3% = 6%.
  2. Risk premium for the stock = 1.4 × 6% = 8.4%.
  3. Required return = 3% + 8.4% = 11.4%.
  4. Option A forgets to add Rf, so it gives only the stock's risk premium (1.4 × 6%).
  5. Option C uses the common wrong formula Rf + β × Rm = 3% + 1.4 × 9% = 3% + 12.6% = 15.6%. It multiplies beta by the market return instead of the premium.

Answer: B. 11.4%

Example 2

Rf = 4% and the market risk premium is 5%. Analyst forecasts: Stock X expected return 9% with beta 1.2; Stock Y expected return 8% with beta 0.6. Which statement is correct? A. X is overvalued and Y is undervalued B. X is undervalued and Y is overvalued C. X is undervalued and Y is undervalued

Show the solution
  1. Required return X = 4% + 1.2 × 5% = 10%.
  2. Forecast for X is 9%, which is below 10%, so alpha = −1% and X is overvalued.
  3. Required return Y = 4% + 0.6 × 5% = 7%.
  4. Forecast for Y is 8%, which is above 7%, so alpha = +1% and Y is undervalued.

Answer: A. X is overvalued and Y is undervalued

Exam tips

  • Questions are three-option MCQs. Compute the required return first, then pick the option; wrong options often come from skipping Rf or using Rm instead of the premium.
  • Read carefully whether the question gives the market return or the market risk premium.
  • Value calls compare forecast return with required return, never forecast return with the market return.
  • Know the CAPM assumptions and the difference between the SML and the CML; both can be tested conceptually.
  • On the BA II Plus in its default chain calculation mode, you can key: 9 − 3 = × 1.4 + 3 =. This gives 11.4. If your calculator is set to AOS mode, the order of operations changes, so check your mode first or key the steps separately.

Practice questions from Portfolio Risk and Return: Part II

Capital Asset Pricing Model 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.

Capital Asset Pricing Model and Security Market Line: frequently asked questions

What is the CAPM formula for CFA Level I?

E(Ri) = Rf + βi × [E(Rm) − Rf]. The term in brackets is the market risk premium. The result is the return investors require for the security's systematic risk.

How do I know if a stock is overvalued or undervalued on the SML?

Plot or compute the required return for its beta, then compare it with your expected return. If the expected return is above the line, the stock is undervalued. If it is below, it is overvalued.

What is the difference between the SML and the CML?

The SML relates required return to beta and applies to any security or portfolio. The CML relates expected return to standard deviation and applies only to efficient portfolios combining the risk-free asset and the market portfolio.

Which CAPM assumptions should I memorize?

Investors are risk averse, use mean-variance analysis, hold the same expectations and plan for one period. They can borrow and lend at the risk-free rate, and markets are frictionless with no taxes or transaction costs. All of this is why the market portfolio is the only risky portfolio held.