Question

The CAPM’s Security Market Line (SML) equation examines the relationship between a security’s market risk and its required rate-of-return. Explain the importance of this relationship from a Finance Management perspective. Explain how market perceptions of risk affect the required rate of return on investment. Explain with examples.

Answer 1

To explain the Security Market Line equation, the relationship between a security's market risk and its required rate of return needs to be discussed and the points are written as below:

• From a finance management perspective, the concept of SML(Security Market Line) and CAPM(Capital Asset Pricing Model) are tools used to gauge the returns over a project with risk.
• SML is mainly used to evaluate which is the riskier project between two risky projects but with the same return. While evaluating this one can get to know whether to invest in the same or not by using this sort of tool.
• Beta plays a crucial role in between CAPM and SML, as it shows the volatility of the risk of any stock and thus showing the riskiness of an asset.
• SML helps by giving out the plots over a graph representing the risk with respect to the return, this will let the shareholders decide whether they have to stay invested or to sell their stake off.

To explain how market perceptions of risk affect the required rate of return on Investment, we'll take some examples as below and discuss further:

• To understand the market perception, one needs to know that the actual return gives the meaning of actual return that will be yielded by holding a stock, and an expected return is the return that is expected by an investor. Market perceptions effect over the actual return by holding biases by the investors.
• Investor's create market perception by showing herd-mentality at times by following a group of shareholder's opinions to sell/buy the stock which is set as an example of market perception, and this may effect over the demand and supply for a stock.
• Also, holding a stock for long term can fetch you higher returns and it proves that ROI can be possibly higher for the highly risky assets. This is also one of the market perception.