Let E(n) denote the expected return on asset i and B. denote the corresponding beta. In addition, let E(rm) denote the expected

Let E(n) denote the expected return on asset i and B. denote the corresponding beta. In addition, let E(rm) denote the expected return on the market portfolio and Bm denote the corresponding beta. Define and sketch the Security Market Line (SML). Hint: Use E(rm) - r = 8%, r = 3%, B. = 1.25 and B2 = 0.6.

Expert Solution

Security market line is the line which gives the relationship between the expected return of a stock and its Beta .

It is given as

E(ri) = rf + Beta(i) * (E(rm) - rf)

= 3%+ Beta(i)* 8%

The graph of Security Market line is shown below:

The market portfolio has a Beta of 1.

and Risk free asset has a beta of 0.

It is assumed that the expected return of a stock only depends on the sensitivity of stock's return to Market return (beta)

So, this model is basically a one factor model (also called as Capital Assets Pricing model)

Security market line is the line which gives the relationship between the expected return of a stock and its Beta .

Junaid answered 2 years ago

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