Discuss the importance of CAPM and SML in determining the trade-off between risk and return.

Expert Solution

Risk return trade off is used to describe the relationship between the risk taken for a security and expected return. Higher the risk undertaken, higher is the return expected from the investment and vice versa. CAPM is used to estimate the expected return on an asset by considering the risk free return, the beta and the market premium. As per CAPM, a higher beta i.e. the volatility associated with the stock and the market premium , higher is the expected return on the stock. The reason being as per CAPM the market premium is multiplied by the beta of the stock. SML is a graphical representation of the CAPM with beta on the horizontal axis and the expected return on the vertical axis. The risk free return is constant and the risk premium lies above it. The area that lies above the risk premium is the return on the asset. SML can be used to judge if the stock is underpriced or overpriced. If the market premium has a downward movement then the stock is underpriced and if it has upward movement it is overpriced.

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