Question

18. Graph and Draw (Basic) the security market line if the market-risk premium is 5% and the risk-free rate is 7%.

a) Suppose that an asset has a beta of -1 and an expected return of 4%. Plot it on the graph you drew. Is the security properly priced? If not, explain what will happen in this market.

b) Suppose that an asset has a beta of 3 and an expected return of 20%. Plot it on the graph you drew. Is the security properly priced? If not, explain what will happen in this market.

Answer 1

Security Market Line = Rf+ Beta*Market Risk Premium.

This line is a representation of CAPM return

Because return as per CAPM = Rf+ Beta*Market Risk Premium.

Rf	market-risk premium	Beta	CAPM return	Expeced return
7%	5%	-1	2%	4%
7%	5%	-0.5	5%
7%	5%	0	7%
7%	5%	0.5	10%
7%	5%	1	12%
7%	5%	1.5	15%
7%	5%	2	17%
7%	5%	2.5	20%
7%	5%	3	22%	20%

(a)

CAPM return shows the Minumum Required return from the stock. As we can see from the above graph that if Beta is -1, the CAPM return or Minimum required return is 2%, where as the stock is Expected to generate 4% return.

The red dot shows that the price is not on the SML line . Hence the stock is not properly priced. The stock is under priced.

Now as the Expected return (4%) is more the the Minimum required return (2%), investors are going to buy the stock more. Due to which the Price will increase and be stable where the CAPM return= Expected return.

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(b)CAPM return shows the Minumum Required return from the stock. As we can see from the above graph that if Beta is 3, the CAPM return or Minimum required return is 22%, where as the stock is Expected to generate only 20% return.

The red dot shows that the price is not on the SML line . Hence the stock is not properly priced. The stock is Over priced.

Now as the Expected return (20%) is less the the Minimum required return (22%), investors are going to sell the stock more. Due to which the Price will decrease and be stable where the CAPM return= Expected return.

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