Professional Documents
Culture Documents
Presented by
Ujjayini Das
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security market line
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Two interpretation of SML
• Each asset may be viewed as a combination of risk-free
assets and market portfolio.
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• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
• But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten
• Slope = E(RM) – Rf = market risk premium
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The Security Market Line
Consider a portfolio composed of the following two
assets:
• An asset that pays a risk-free return Rf, , and
• A market portfolio that contains some of every risky
asset in the market.
Portfolio E(R) Beta
Risk-free asset Rf 0
Market portfolio E(Rm) 1
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The Security Market Line
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The Security Market Line
E(RP)
A - Undervalued SML
•
•
A
RM • B • Slope = (y2-y1) / (x2-x1)
• = [E(RM) – RF] / (βM-0)
= [E(RM) – RF] / (1-0)
= E(RM) – RF
RF
• B - Overvalued = Market Risk Premium
•
M =1.0 i
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Required Return
• The return that a rational investor should
demand is therefore based on market rates and
the beta risk of the investment.
• To find this, solve for the required return in the
CAPM:
R (k ) R f s [k M R f ]
• This is a formula for the straight line that is the
SML.
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CML VS SML
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• A rightly priced security will lie exactly on
SML.
• ALL the efficient portfolios of the CML lie
on the SML, BT the converse is not true.
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Thank you
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