Question

1. Explain how the SML divides the universe of assets into undervalued and overvalued. Use a graph to support your argument.

Answer 1

The SML is a graphical representation of the CAPM model, where the x axis is the beta , the y axis is the expected return on a security, the risk free rate is the intercept and the slope of the line determines the risk premium.

Now, the SML depicts the required return on a security given the beta of the stock, of the beta is zero, the return on the stock will be the risk free rate.

In the real world, transaction costs are different and people have different abilities to lend and borrow at the risk free rate, so in the real world the position of the stock can be different either below or above the SML.

Undervalued stocks are the stocks that provide a return that is higher than the return expected from CAPM, so these securities are depicted above the SML. The overvalued securities are depicted below the SML as they provide return which is lower than that depicted by the CAPM.

Explained graphically: