Question

describe the CAPM and explain the SML graph in words. If a security is underpriced, where will it be represented on the SML graph?

Answer 1

Solution.>

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks.

Accroding to the CAPM equation,

Expected return = Risk Free rate + Beta * ( Market Return - Risk Free rate)

Security Market Line (SML) is a graph that tracks the necessary return on investment by reference to its beta coefficient, a systematic risk indicator. The security market line represents the capital asset pricing model which calculates the returns expected equal to the risk-free rate plus the beta coefficient product and the market risk premium.

The security market line differs from the capital market line (CML) that plots the necessary return on a risk-free asset portfolio and the stock portfolio by reference to the standard deviation of the portfolio.

The formula is :

Re = Rf + b * ( Rm-Rf )  

Where Re is the required return on an asset, Rf is the risk-free rate, β is the beta coefficient and Rm is the market risk.

The graph is:

If the point occurs above the SML, then they are considered undervalued because their observed required returns (as per DDM) are higher than the justified required returns (as per CAPM) and they appear above the security market line. For e.g. points B and D as shown in the above graph.

If the point occurs below the SML, then they are also considered overvalued because their observed required returns are lower than required returns that should prevail given their systematic risk. For e.g. points A and C as shown in the above graph.

If the point occurs on the SML, then they are considered fairly-valued because its observed required return and CAPM required return are same. For e.g. Point E as shown in the graph.

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