Financial Management in IB

The Security Market Line

Return, Risk and the Security Market Line

RETURN AND RISK
From capital market history we can learn that there is a
reward, on average, for bearing the risk.

Investors require higher expected return for bearing the

risk.
Risk can be measured by the variance or standard
deviation (square root of the variance)

Return, Risk and the Security Market Line

RETURN AND RISK - EXAMPLE
There are two assets and two states of economy. What are the
expected returns and standard deviations for these two stocks?

State of Economy

Probability

Rate of Return
Stock A

Rate of Return
Stock B

Recession

0.50

-20%

30%

Boom

0.50

70%

10%

Return, Risk and the Security Market Line

RETURN AND RISK PORTFOLIO
Portfolio is a group of assets such as stocks and bonds
held by investors.

Portfolio expected return is a weighted average of

expected returns on the assets in that portfolio.
However, portfolio variance is not generally simple
combination of the particular variances, since there is so
called diversification effect.

Thus, risk can be reduced by creating the portfolio.

Return, Risk and the Security Market Line

RETURN AND RISK
Risk can be divided to systematic and unsystematic
risks.

Systematic risks (or market risks) are unanticipated

events that affect almost all assets to some degree because
the effects are economywide.
Unsystematic risk are unanticipated events that affect
single assets or small group of assets. Unsystematic risks
are also unique or asset-specific risks.
5

Return, Risk and the Security Market Line

RETURN AND RISK - DIFERSIFICATION
Some, but not all, of the risk associated with a risky
investment can be eliminated by diversification because
unsystematic risks, which are unique, tend to wash out in
a large portfolios.
However, systematic risks can not be eliminated by the
diversification.
Because unsystematic risks can be freely eliminated by
the diversification, reward for bearing risk depends only
on the level of systematic risk.
6

Return, Risk and the Security Market Line

RETURN AND RISK - DIFERSIFICATION
The systematic risk for particular asset can be measured
by beta coefficient, beta for short .

Beta tells us how much systematic risk a particular asset

has relative to an average asset.
An average asset has beta of 1. An asset with a beta of
0.50, therefore, has half as much systematic risk as an
average asset; an asset with a beta of 2.0 has twice as
much.
7

Return, Risk and the Security Market Line

SECURITY MARKET LINE
To see how risk is rewarded in the marketplace we can
construct different portfolios consisting of one risky asset
and one risk-free asset.
The more risk we take (higher beta) the higher expected
return we get.
If we plot expected returns against different betas, we
will see that all portfolios plot on the same straight line.
8

Return, Risk and the Security Market Line

SECURITY MARKET LINE
The slope of this line is called reward-to-risk ratio and
equals the ratio of assets risk premium to its beta.

In a well-functioning market, this ratio must be the same

for every asset. As a result, all assets plot on the same line,
called the security market line.
If we plot expected returns against different betas, we
will see that all portfolios plot on the same straight line.
9

Return, Risk and the Security Market Line

SECURITY MARKET LINE
Market portfolio of all assets has the beta of 1 and plots
on the SML. Thus, we can simply derive basic formula for
The Capital Asset Pricing Model (CAPM):
E(Ri) = Rf + i x [E(RM) - Rf]
The expected return on risky asset i depends on the pure
time value of money as measured by the risk-free rate Rf,
the reward for bearing systematic risk as measured by the
market risk premium E(RM) RF, and the amount of
systematic risk in asset i as measured by the beta i.
10