Security Market Line
Can plot what the CAPM says E(R) should be as a function of beta E(R) on Y axis, beta on X axis : Do this next . Note this is not the same graph as mean-sigma! What's on the X-axis?
Example
Rf is 5%. The market risk premium for the next year is 8%. What does the CAPM say the expected return should be on stocks that have the following betas: A: +1 B: 0 C: -0.5 Can plot these on the SML
Rf is 5%. The market risk premium for the next year is 8%. What does the CAPM say the expected return should be on stocks that have the following betas: A: +1 . B: 0 . C: -0.5 An analyst tells you that the expected return on the stocks actually is: 13% on A, 4% on B, 2% on C. Which stocks do you buy? Can plot on the SML graph
Assumptions
Market is in competitive equilibrium : Competitive : Equilibrium Single period investment horizon .Everyone agrees All assets are tradable, available to everyone No transactions costs, no taxes No short selling restrictions, no borrowing/lending restrictions Investors are mean-variance optimizers with Homogeneous expectations Everyone sees the same assets, and agrees on those assets' means, variances and covariance