Question

How do you write a the security characteristic line equation (SCL) using the regression outputm with using stock returns?

Answer 1

Answer :-

Capital asset pricing model (CAPM) describes the linear relationship between risk-return trade-off for the securities / portfolios. CAPM method distinguishes between risk of holding a single asset and holding a portfolio of assets. There is a trade-off between risk and return. A graphical representation of CAPM method is the security characteristics line equation, (SCL), which indicates the rate of return required to compensate at a given level of risk. The risks to which a security / portfolio is exposed are divided into two groups, diversifiable and non-diversifiable.

The diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified securities. Whereas, the non-diversifiable risk is attributable to factors that affect businesses like interest rate changes, inflation, political changes etc. As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk is the only risk a business should be concerned with. The CAPM method is solely concerned with non-diversifiable risk.

During graphical representation of  CAPM method i.e., security characteristics line equation (SCL), The non-diversifiable risks are assessed in terms of beta coefficient, β, through fitting regression equation between return of a security / portfolio and the return on a market portfolio.

Required return = Risk free rate of return + Beta * (Market rate of return - Risk free rate of return).

(The above mentioned equation is security characteristics line equation).