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Risk-Return Relationship

## Is security market line the same as CAPM?

The Security Market Line (SML) is a visual representation of the Capital Asset Pricing Model (CAPM). The SML is a theoretical representation of the expected return on an asset based on systematic, non-diversifiable risk.

## What does the security market line depicts?

The Security Market Line is a visual representation of the Capital Asset Pricing Model (CAPM). It shows the relationship between the expected return of an investment and the level of risk associated with the investment.

## What is the relationship between CAPM and SML?

Key Points The CAPM is the formula that produces the expected return. Beta is an input to the CAPM and measures the volatility of a security relative to the overall market. SML is a graphical representation of the CAPM and plots risk against expected return.

## What does the slope of the security market line represent?

The slope of the security market line represents the market risk premium, or excess return over market return.

## How do you interpret CAPM results?

Decomposition of the CAPM formula The equity beta is 1.5, making it riskier than the overall market. Also, assume that the risk-free interest rate is 3% and the investor expects the market to increase in value by 5% per year. The expected return on the stock based on CAPM is 6%.

## How do you read a security market line?

The two-dimensional correlation between expected return and beta can be calculated using the CAPM formula and represented graphically using the Securities Market Line (SML). Securities plotted above the SML are interpreted as undervalued. Securities below the line are overvalued.

## What does the security market line depict quizlet?

What do the security market lines indicate? -It represents the relationship between systematic and unsystematic risk.

## What are the advantages of security market line?

Benefits of SML: Plays a key role in portfolio planning and management. It helps investors and portfolio managers make rational investment decisions by charting expected returns from securities and asset classes. The model does not ignore systematic or market risk while providing expected returns.

## What does it mean if a stock plots on a security market line SML graph to the left of the market portfolio?

What does it mean when a stock is plotted on the Securities Market Line (SML) graph on the left side of the market portfolio? Stocks have a beta of less than 1, which means they have less market risk than the market portfolio.

## What does CAPM value mean?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of an investment in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium based on the security’s beta.

## What is the expected return beta relationship?

In the Capital Asset Pricing Model, the statement that the expected return on an investment is directly proportional to its risk premium, as indicated by its beta.

## Is a positively sloped straight line displaying the relationship between expected return and beta?

Security Market Line (SML): This is a straight line with a positive slope where the x-axis represents the beta or risk of the asset and the y-axis represents the expected return. The purpose of the graph is to identify the action or slope of the market risk premium.

This represents the payment to an investor for allowing the extra risk of a particular investment over a risk-free asset. For example, a high quality bond issued by an established company with large profits typically has little risk of default.

## What is the expected return on the market quizlet?

– If enough securities are added, all non-systematic risks of the securities in the portfolio should cancel each other. What is the definition of expected return? Return is what an investor expects to earn on a risky asset in the future.

## What does a negative SML mean?

Empirically, SML plots have a negative slope, i.e., low beta stock (value) has a higher expected rate of return than high beta stock (growth).

## Which one of the following is the formula that explains the relationship between the expected return?

Which of the following formulas describes the relationship between the expected return on a security and the level of systematic risk of that security? The weighted average of the returns for each economic state.

The risk premium of a security is a function of the market risk premium, R_{m} – R_{f}and varies directly with the level of beta. (Of course, no non-systematic measure of risk appears in the risk premium because the CAPM diversification world has eliminated it.)

## What type of relationship do risk and return have?

In general, the higher the potential return on an investment, the higher the risk. There is no guarantee that accepting more risk will actually yield a higher return. Diversification can reduce portfolio risk without sacrificing potential returns.

## What’s the relationship between risk and return?

The risk-return tradeoff is that the higher the risk, the higher the reward, and vice versa. Using this principle, lower levels of uncertainty (risk) are associated with potential returns and higher levels of uncertainty associated with potential returns.

## When graphing the security market line SML Which one of the following statements is correct?

Correct. A security above the security market line (SML) has a higher expected return than that predicted by the capital asset pricing model (CAPM). Higher than expected means that the current security price is lower than its intrinsic value.

## What are the 4 components of the Capital Asset Pricing Model CAPM equation?

What are the components of the CAPM equation?

- Explain the dividend growth model.
- Define cost of capital.
- Define the weighted average cost of capital (WACC).

## How would the security market line be affected other things held constant?

If the expected inflation rate decreases and investors also become more risk averse, the security market line is affected as follows, other things being held constant: The intercept on the Y-axis decreases and the slope increases.

## How do you determine if a stock is undervalued or overvalued using CAPM?

Beta is an input to CAPM and measures the volatility of a security relative to the overall market. SML is a graphical depiction of the CAPM and plots risk versus expected return. A security plotted above the security market line is considered undervalued, while one below the SML is overvalued.

## How do you interpret alpha in CAPM?

Alpha for portfolio managers. It is usually a higher bar. If a CAPM analysis shows that the portfolio should have earned 5% based on risk, economic conditions, and other factors, but the portfolio earned only 3%, the portfolio alpha would discourage -2%.

## What does the security market line depict quizlet?

What do the security market lines indicate? -It represents the relationship between systematic and unsystematic risk.

## How is security market line calculated?

According to the equation in the security market line, the expected return on security A is as follows.

- E(R
_{A}) = R_{f}+ β_{i}[e(r_{M}) – R_{f}] - E(R
_{A}) = 5 + 0.5 [14 – 5] - E(R
_{A}) = 5 + 0.5 x 9 = 9.5

## What will happen to the market price of the security if its correlation with the market portfolio doubles while all other variables including the dividend remain unchanged?

Assume that the stock is expected to pay a constant dividend in perpetuity. If the correlation coefficient of the security with the market portfolio doubles (all other variables, such as mutations, remain unchanged), the beta and therefore the risk premium will also double.

The market risk premium is the difference between the expected rate of return on the market portfolio and the risk-free rate. It provides a quantitative measure of the extra return that market participants demand for an increase in risk.

When you invest in risky assets like stocks, you risk losing money. This is where the risk premium comes in. Risky investments offer the potential for higher returns and compensate the investor for taking away the risk of losing money.

## How do we calculate the expected return on a security?

Expected return is the loss or loss the investor can expect from the investment. reguids return = (x returns probability a) + (b x returns probability b).

- First, determine the probability of each possible return occurring.
- Next, determine the expected return for each possible return.

## What is the expected return on a security with beta of 1?

However, if the beta equals 1, the expected return of the security equals the average market return. A beta of -1 means that the security has a perfectly negative correlation with the market.

## How does CAPM influence financial decisions?

Investors use the CAPM when they want to assess the fair value of a stock. So if the level of risk changes or other factors in the market make the investment risky, the formula can be used to help re-determine pricing and projections of expected returns.

## What does a downward sloping SML mean?

Strongly Negative Slope Page 7 6 coefficient implies a downward sloping SML line. In other words, the higher the market beta of the stock, the lower the expected return. Higher beta stocks underperform due to lower beta stocks in absolute terms.

## Can SML be downward sloping?

Allowing assets to enter into uneven supplies has a similar effect and may cause econometricians to perceive a downward sloping security market line, even though the actual SML is always an upward slope.

## Which of the following is on the horizontal axis of the Security Market Line?

Given us: which of the following is on the horizontal axis of the security market line? The correct option is option number A, expected return. Expected return is the profit or loss that an investor would expect on an investment with a known historical rate of return (ROR).

## Which one of the following is the relation between the expected return on a security and the level of that security’s systematic risk?

Which of the following formulas describes the relationship between the expected return on a security and the level of systematic risk of that security? The weighted average of the returns for each economic state.

## What are the basic assumptions of CAPM?

The CAPM assumes the availability of risk-free assets to simplify the complex, paired covariance of Markowitz’s theory. Riskless assets lead to the curved efficient frontier of the MPT, simplifying the linear efficient frontier of the CAPM.