Question

The Capital Asset Pricing Model (CAPM) suggests that each and every stock MUST lie on the Security Market Line. Explain why?

Answer 1

As we know that Security Market Line is graphical representation of Capital Asset Pricing Model so it is absoluely correct statement that  Capital Asset Pricing Model (CAPM) suggests that each and every stock MUST lie on the Security Market Line,For understaning why its happen we have to understand Capital Asset Pricing Model and Security Market Line.

Capital Asset Pricing Model (CAPM);The capital asset pricing model (CAPM) explain linear relationship between the expected excess return of the security and the expected excess return of the market.As we know that unsystematic risk can be averted through diversification but systematic risk cannot be averted by diversification.It is market related component of prtfolio risk which is measured by Beta where high Beta reflect high risk and low Beta reflect low risk.

Securities are priced, such a way that the holders of risky portfolio are expected to get more return compare to holders of risk-free securities,

The expected reurn on portfolio is calculated under CAPM by following formulae;

Rp = Rf + Bp (Rm - Rf)

Where Rp = the expected returns of portfolio p

Rf = the risk free rate.

Rm= the expected returns on the market

Bp=Beta of portfolio

. ,Security Market Line;it is graphical representation of CAPM model.

. The security market line has two axis, the x-axis and the y-axis. While the x-axis represents the beta or the risk of the assets, the y-axis represents the expected return of the assets.

The x-axis of the SML graph is represented by the beta, and the y-axis is represented by the expected return. The value of the risk-free rate is the beginning of the line,It is also called characteristics line.