Question

1. Explain how you would use the Security Market Line (SML) to discern the breadth of a portfolio’s individual stock winners vs. losers.

2. Explain how the link between price (P) and intrinsic value (V) are viewed by proponents of the Efficient Market Hypothesis and by those who are not proponents.

Answer 1

1) CAPM model also known as Capital asset pricing model shows the corelation between an assets expected return and Beta, this co-relation can be calculated with the help of CAPM and expressed graphically through a security market line.Any security plotted above the SML is interpreted as undervalued. A security below the line is overvalued.This signifies that, the securities plotted above the SML is uncervalued has the opportunity to be the stock winners however the securities plotted below the the SML are overvalued and may change into stock losers.

2)Efficient Market Hypothesis propogates that share trade at fairvalue in the Exchanges. The link between Price and Intrinsic value is viewed as if the Price is reasonable or equal to the Intrinsic value of the share EMH proponents  posit that investors benefit from investing in a low-cost, passive portfolio and hence its always profitable to invest in share which have pricing in line with its intrinsic value, However, Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values, and that the link between Price and intrinsic value does not really work in practical world and can be easily beaten.