Session 10

Beta = covariance between stock return and market return/ variance of market return

Rm = market return

RF = risk free rate of return

Ri = stock return

Rp = portfolio return

E(R) = expected return

CAPM = capital asset pricing model

SML = security market line ---- stock return and beta

CML= capital market line --- portfolio return and total risk

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM).
The SML can help to determine whether an investment product would offer a favorable
return compared to its level of risk.
Example

Capital Asset Pricing Model

Ri = Rf + (Rm – Rf ) βi
E RF Beta x Require Valuation Investment if Ri> RF=
Rf R
S.N Bet (R Deb (RM-RF) d return decision or equity
(% m
o a ) t or Risk or buy /sell otherwis
) %
% premiu Return e debt
m under
CAPM
1 8 -1 12 4 8 -4 4 Correctly Indifferenc Debt
valued e
2 8 -0.5 12 15 8 -2 6 Undervalue Sell Debt
d
3 8 0 12 8 8 0 8 Correctly Indifferenc Debt
valued e
4 8 0.5 12 15 8 2 10 Undervalue Sell Equity
d
5 8 1 12 15 8 4 12 Undervalue sell Equity
d
6 8 1.5 12 14 8 6 14 Correctly Indifferenc Equity
valued e
7 8 2 12 15 8 8 16 Overvalued Buy Equity
8 8 2.5 12 15 8 10 18 Overvalued Buy Equity
9 8 3 12 15 8 12 20 Overvalued Buy Equity

1. beta x (Rm-RF) = -1 (12-8)= -4

 overvalued/undervalued
expected return > return under CAPM/ required rate of return- undervalued
expected return < return under CAPM/ required rate of return- overvalued

Graph

Security Market Line (SML)

25

20
20
18
Required rate of return

16
15 15 15 15 15 15
15 14
12
10
10
8 8 8 8 8 8 8 8 8
6
4 5

0
-1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5
Beta

Characteristics of Security Market Line (SML) are as below

 SML is a good representation of investment opportunity cost which provides the
combination of the risk-free asset and the market portfolio.
 Zero-beta security or zero-beta portfolio has an expected return on the portfolio which
is equal to the risk-free rate
 The slope of the Security Market Line is determined by market risk premium which
is: (E(RM) – Rf). Higher the market risk premium steeper the slope and vice-versa
 All the assets which are correctly priced are represented on SML
 The assets which are above the SML are undervalued as they give the higher expected
return for a given amount of risk.
 The assets which are below the SML are overvalued as they have lower expected
returns for the same amount of risk.

https://ift.world/concept1/concept-66-applications-capm-sml/