Question

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

(Please type the answer/explanation, English is my second language and some PDFs are difficult to read, thanks!)

Answer 1

Security Market line is the representation of capital asset pricing model. It is used to display an expected rate of return of individual security as a function of systematic risk, non diversifiable risk.

Security Market line is used to graph the beta against the return of the whole market and it used to find the risky securities.

The Y intercept of SML is equal to risk free rate. When it is used in the portfolio management, It depicts the investment opportunity cost. All the correctly priced securities are plotted on the SML. The assets which lie above the line are believed to be undervalued because they yield a higher rate of return for a given amount of risk. Similarly, The assets which lie below the SML are believed to be overvalued as they yield a lower return for a given amount of risk.

The slope of the security market line is equal to market risk premium and it is used to reflect the risk return trade-off stba given period of time.

It can be said that a security market line suggests that an investor requires compensation in form of expected return for the exposure of risk arising out of investment in a particular security. Capital investment below the SML wouldn't be effectively priced to the buyer and Capital market above the SML wouldn't be effectively priced for the seller.

Overall we can say that It is an important concept and location of financial instruments above or below the line are used to interpret different scenarios of investment for an investor and it will also lead to consequences for cost of capital of a company.