The Security Market Line: Setting The Capital Asset Pricing Model

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Security market line (SML) is a line on a chart representing the capital asset pricing model (CAPM). The security market line plots risk versus expected return of the market. The security market line is a useful tool in determining the relationship between risk and return for individual securities. If a security plots the security market line, it indicates a higher expected return for a given level of risk than the market. The security market line shows a positive linear relationship between returns and systematic risk as measured by beta (Boundless, 2016, para.2). The SML essentially graphs the results from the CAPM formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is used in …show more content…

The beta is the relevant measure of risk. Formulas that show a stock with high standard deviation will have a high beta which shows that the stock has a high risk (p.257). Sharpe (2016), states that the CAPM model is only valid with the following assumptions: (1) investors are risk adverse individuals who wish to maximize their investment; (2) investors have similar expectations about asset returns and everyone has the same information at the same time; (3) assets are distributed by normal distribution; (4) investors can borrow or lend assets at a constant rate; (5) a definite number of assets and quantities are fixed in one period; (6) assets are divisible and priced in a competitive market; (7) asset markets are frictionless information and is costless and available to all investors; (8) there are no market imperfections such as taxes or regulations. The formula used is expected security returns=riskless returns + beta X (expected market risk premium) r=RF+Beta x (RM-RF)

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