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Lecture 15

Lecture 15

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Published by: Aditya on Jun 08, 2010
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11/15/2013

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Lesson- 15 Security Market LineObjectives:
After completion of this lesson you will be able to understand therelationships between co-variance and market.
By now CAPM must be clear to you, so that will help you while understanding thislesson: “
THE SECURITY MARKET LINE (SML)”. After completion of this lessonyou will get better idea about CAPM.Let’s start with the implication of Individual Risky Assets
 The Capital Market Line represents the equilibrium relationship between the expectedreturn and standard deviation for the efficient portfolios. Individual risky securities willalways plot below the line because a single risky security when held by it is an inefficient portfolio. The Capital Asset Pricing Model does not imply any particular relationship between the expected return and the standard deviation (that is, total risk) of an individualsecurity. To say more about the expected return of an individual security, deeper analysisis necessary.Following is the equation for calculating the standard deviation of any portfolio:
1/ 2
 
i=1=1
1/ 2
 
σ
 
P
=
Σ
 
Σ
 
X
i
 
X
 j
 
σ
 
ij
1where X
i
and X
 j
denoted the proportions invested in securities
i
and
 j
, respectively, anddenoted the covariance of returns between security and i and j. Now consider using thisequation to calculate the standard deviation of the market portfolio.
i=1
 
=1
σ
M
=
Σ
 
Σ
 
X
iM
 
X
 jM
 
σ
ij
2
 
where X
iM
and X
 jM
denote the proportions invested in securities
i
and
 j
in forming themarket portfolio, respectively. It can be shown that another way to write the aboveequation is as follows:
=1 =1=1
1/ 2
=1
 
σ
M
= X
1M 
 
Σ
 
X
 JM 
 
σ
1j
 
+ X
2M 
Σ
X
 JM 
 
2j
+ X
3M 
 
Σ
 
X
 jm
3
 j
3+ ............. + X
 NM 
 
Σ
 
X
 jm
 
σ
 Nj
At this point a property of covariance can be used: the covariance of security
i
with themarket portfolio (
σ
im
) can be expressed as the weighted average of every security’scovariance with security
i
:
=1
Σ
 
X
 JM 
 
σ
1j
 
=
σ
iM 
4This property, when applied to each one of the
 N 
risky securities in the market portfolio,results in the following:
σ
= [ X
1M
 
σ
1M
+ X
2M
 
σ
2
+ X
3M
 
σ
3
+ ...... + X
 N 
M
 
σ
 NM 
]
1/2
5Where
σ
1M 
denotes the covariance of security 1 with the market portfolio,
σ
2M
denotesthe covariance of security 2 with the market portfolio, and so on. Thus the standarddeviation of the market portfolio is equal to square root of a weighted average of thecovariance of all securities with it, where the weights are equal to the proportions of therespective securities in the market portfolio.At this juncture an important point can be observed. Under the CAPM, eachinvestor holds the market portfolio and is concerned with its standard deviation becausethis will influence the slope of the CML and hence the magnitude of his or her investment
 
in the market portfolio. The contribution of each security to the standard deviation of themarket portfolio can be seen Equation 5 to depend on the size of its covariance with themarket portfolio. Accordingly each investor will note that
the relevant measure of risk for a security is its covariance with the market portfolio
,
σ
im
. This mean that securities withlarger values of 
σ
im
will be viewed by investors as contributing more to the risk of themarket portfolio. It also means that securities with larger standard deviations should not be viewed as necessarily adding more risk to the market portfolio than those securitieswith smaller deviations.From this analysis it follows that securities with larger values for have to provide proportionately larger expected returns to interest investors in purchasing them. To seewhy consider what would happen if such securities did not provide investors with proportionately larger levels of expected return. In this situation, these securities wouldcontribute to the risk of the market portfolio. This means that deleting such securitiesfrom the market portfolio would cause the expected return of the market portfolio relativeto its standard deviation to rise. Because investors would view this as a favorable change,the market portfolio would no longer be the optimal risky portfolio to hold. Thus security prices would be out of equilibrium.The exact form of the equilibrium relationship between risk and return can bewritten as follows:
m
-
 f 
 
i
 
=
 f 
+ ----------
σ
 
iM 
6
σ
 
2
 As you can see in panel (a) of Figure A, Equation 6 represents a straight line having avertical intercept of
and a slope of [(r 
m
)
σ
2
 
m
/]. As the slope is positive, theequation indicates that securities with larger covariance with the market (
σ
im
) will be prices so as to have larger expected returns (r 
i
). This relationship between covariance andexpected return is known as the
Security Market Line
(SML).

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