Question

Please discuss how investors should consider and interpret different categories/types of investments with the security market line.

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

The security market line gives the formula of Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)B

Re= required rate of return.
Rf= Risk-free rate.
Rm = return on the market.
Rm-Rf =Market Risk Premium.
B = Beta, systematic risk.

Re is represented by the y-axis.
Rm, Rf lies in the X-axis.
B is represented by the y-axis.

It shows the relationship how the Return of Market prices Individual securities (Re) in relation to its security class risk (B).

Beta that is systematic risk is determined by: Rate of change of stock return to the rate of change of market return. It is the sensitivity of stock return to Market return.

They are three types of Investment:
a. Lower beta Investments (that is Beta less than 1). They have low risk & hence are expected to provide lower Returns.

b. Market beta Investments (that is Beta equal than 1). They have the risk of the market & hence are expected to provide market returns.

c. Higher beta Investments (that is Beta more than 1). They have high risk & generally are expected to provide higher Returns.