Question

1. Under the framework of the CAPM, what is the slope of SML? Draw the SML graph and use it to show the expected rate of return is if beta is 0? In practice, what do we use as a proxy for the “Market Portfolio”?

Answer 1

The Security Market Line (SML) is the graphical representation of the Capital Asset Pricing Model (CAPM). CAPM defines the relationship between the expected return and risk of a security. This risk is denoted by the beta coefficient of the security, so the SML depicts the linear relationship between expected return and beta of a security. CAPM equation is given by

E(R) = Rf + B*(Rm-Rf) where E(R) = expected return of the security; Rf = risk-free rate of the market; B = beta coefficient of the security; Rm = market return

The SML is depicted as below:

As can be seen from the graph, the return at which beta is zero, is the risk free rate. In practice, any market index such as the S&P 500 can be taken as a good representative of the market and its return is taken to be a good approximation of the market return.