Question

briefly describe the concept of the security market line(sml), and explain why all assets must plot directly on it in a conpetitive market

Answer 1

SML is a line use to represent CAPM through graphical representation.

It related systematic risk with required return. Syatematic risk is measure using Beta. Systemtic risk shows the market risk of the given asset.

Require Return = Rf + Beta * ( Market return - Rf)

Here we multiply market return in excess of risk free rate with beta to compensate for the risk.

Beta =1 can be used to get market return.

From the above graph it is clear that as beta increases, require return is on getting increased.

All asset should be plot on SML to avoid arbitrage profit opportunity.

A stock will be undervalued when return is higher than SML. Hence investor will buy this stock and sell it at higher price to get arbitrage profit.

A stock will be overvalued when return is lowerr than SML. Hence investor will sell this stock and buy at lower price to get arbitrage profit.\