Question

Important : Draw the Security Market Line and label the axes. Include the market risk premium in your diagram. Also include an underpriced asset

Please draw the diagram and label it properly

Answer 1

Security market line (SML) is the graphical representation of the Capital Asset Pricing Model and gives the expected return of the market at different levels of systematic or market risk. It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets and y-axis represents the expected return.

SML: E(Ri) = Rf + βi [E(RM) – Rf]

In the above security market line formula:

• E(Ri) is the expected return on the security
• Rf is the risk-free rate and represents the y-intercept of the SML
• βi is a non-diversifiable or systematic risk. It is the most important factor in SML. We will discuss this in detail in this article.
• E(RM) is expected return on market portfolio M.
• E(RM) – Rf  is known as Market Risk Premium

All the correctly priced securities are plotted on the SML. The assets that lie above the line are undervalued/ underpriced because for a given amount of risk, they yield a higher return. The assets below the line are overvalued because for a given amount of risk, they yield a lower return.