Question

Risk free rate of return is 5% & required rate of return on the market is 9%. What is the security market line? If corporate beta is 1.8 what does that mean?

Answer 1

Security market line is the relationship between Required return on security and beta and it is given by :-

Required return = Risk free rate + (Market return - Risk free rate )*Beta

Hence , Required return= 5+(9-5)*Beta

Required return= 5 + 4 *Beta

This is security market line.

Now when corporate beta is 1.8 ,it means when market changes by 1% then security changes by 1.8 % and when beta is 1.8 then Required return on security =5+4*1.8=12.2%