Asked by Bryan Cakir on Jun 05, 2024
Verified
Draw the SML and plot asset C such that it has less risk than the market but plots above the SML, and asset D such that it has more risk than the market and plots below the SML. (Be sure to indicate where the market portfolio is on your graph.) Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium.
SML
The Security Market Line (SML) represents the relationship between the expected return of a market security and its risk, measured by beta, within the Capital Asset Pricing Model (CAPM).
Market Portfolio
A theoretical bundle of investments that includes every type of asset available in the market, with each asset weighted by its total market capitalization.
- Explain the significance of the Security Market Line (SML) and its relationship with the CAPM.
Verified Answer
SF
Sikdar FahimaJun 05, 2024
Final Answer :
The student should draw a picture similar to Figure 13.9, adding a point where the market portfolio exists. In this case, asset C is underpriced and asset D is overpriced. This condition cannot persist in equilibrium because investors will buy C with its high expected return and sell D with its low expected return. The resultant buy and sell activity will force the prices back to a level that eventually causes both C and D to plot on the SML.
Learning Objectives
- Explain the significance of the Security Market Line (SML) and its relationship with the CAPM.