Question

What is the distance between the Security Market Line and the expected rate of an investment indicate?

Answer 1

Risk premium: The distance between the SML and the expected rate of return of an investment is the risk premium.

Security Market Line : It is a graphical representation of the Capital asset pricing model (CAPM) , in which expected rate of return of the market as a whole is plotted against the systematic risk or market risk. It is used for understanding if the security is offering expected return considering its level of risk. If the expected return is above the SML , it is considered to be undervalued, since it means the security offers greater return as compared to its inherent risk. On the other hand, if the security return falls below the SML it is considered to be overvalued. This is because the security is offering returns lower than risk of holding the security. Higher is the distance between the SML and expected return higher is the stock under or over valued. Thus, the distance between the SML and the expected rate of return indicates the risk premium on the investment.

Since the market is rarely in equilibrium, the actual return is different from that of the expected return, this difference is known as alpha. When actual return is greater than the expected return, then the alpha is positive, conversely, it is negative.