Consider the Security Market Line (SML). What determines its...

Name: Problem 11, Chapter 34: Economics Principles, Problems, and Policies
Uploaded: 2020-07-09T05:15:49-08:00
Duration: 1 min 12 s
Channel: Achintya Suden
Description: Consider the Security Market Line (SML). What determines its vertical intercept? What determines its slope? And what will happen to an asset's price if it initially plots onto a point above the SML?

Consider the Security Market Line (SML). What determines its vertical intercept? What determines its slope? And what will happen to an asset's price if it initially plots onto a point above the SML?

Key Concepts

Security Market Line (SML)

The Security Market Line is a graphical representation of the Capital Asset Pricing Model (CAPM) that shows the relationship between expected return and systematic risk (beta) for individual assets or portfolios. It indicates how much return an investor should expect for taking on additional risk, serving as a benchmark to evaluate whether assets are fairly priced based on their risk profile.

Risk-Free Rate

The vertical intercept of the SML is determined by the risk-free rate. This is because the risk-free rate represents the return an investor would expect from an investment that carries no risk, and it forms the baseline from which additional returns for bearing risk are calculated.

Market Risk Premium

The slope of the SML is determined by the market risk premium, which is the difference between the expected market return and the risk-free rate. This premium represents the extra return investors require for taking on the risk of the overall market relative to a risk-free asset, quantifying the reward per unit of systematic risk.

Asset Price Adjustment

If an asset initially plots above the SML, it implies that the asset offers a higher expected return for its level of systematic risk compared to what is predicted by the CAPM. In an efficient market, such an asset would be considered undervalued, leading investors to buy it, which increases its price until its expected return adjusts to align with the SML.

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