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Lesson- 15 Security Market Line

Objectives:

After completion of this lesson you will be able to understand the


relationships between co-variance and market.

By now CAPM must be clear to you, so that will help you while understanding this
lesson: “THE SECURITY MARKET LINE (SML)”. After completion of this lesson
you will get better idea about CAPM.

Let’s start with the implication of Individual Risky Assets


The Capital Market Line represents the equilibrium relationship between the expected
return and standard deviation for the efficient portfolios. Individual risky securities will
always plot below the line because a single risky security when held by it is an inefficient
portfolio. The Capital Asset Pricing Model does not imply any particular relationship
between the expected return and the standard deviation (that is, total risk) of an individual
security. To say more about the expected return of an individual security, deeper analysis
is necessary.
Following is the equation for calculating the standard deviation of any portfolio:

1/ 2
N N
σP= Σ Σ X i X j σ ij 1
i=1 j=1

where Xi and Xj denoted the proportions invested in securities i and j, respectively, and
denoted the covariance of returns between security and i and j. Now consider using this
equation to calculate the standard deviation of the market portfolio.

N N 1/ 2
σM = Σ Σ XiM XjM σij 2
i=1 j=1
where XiM and XjM denote the proportions invested in securities i and j in forming the
market portfolio, respectively. It can be shown that another way to write the above
equation is as follows:

N N N
σM = X1M Σ XJM σ1j + X2M Σ XJM 2j + X3M Σ Xjm 3j 3
j=1 j=1 j=1
N 1/ 2
+ ............. + XNM Σ Xjm σNj
j=1

At this point a property of covariance can be used: the covariance of security i with the
market portfolio (σim) can be expressed as the weighted average of every security’s
covariance with security i:

Σ XJM σ1j = σiM 4


j=1

This property, when applied to each one of the N risky securities in the market portfolio,
results in the following:

σM = [ X1M σ1M + X2M σ2M + X3M σ3M + ...... + XNM σNM]1/2 5

Where σ1M denotes the covariance of security 1 with the market portfolio, σ2M denotes
the covariance of security 2 with the market portfolio, and so on. Thus the standard
deviation of the market portfolio is equal to square root of a weighted average of the
covariance of all securities with it, where the weights are equal to the proportions of the
respective securities in the market portfolio.

At this juncture an important point can be observed. Under the CAPM, each
investor holds the market portfolio and is concerned with its standard deviation because
this will influence the slope of the CML and hence the magnitude of his or her investment
in the market portfolio. The contribution of each security to the standard deviation of the
market portfolio can be seen Equation 5 to depend on the size of its covariance with the
market portfolio. Accordingly each investor will note that the relevant measure of risk for
a security is its covariance with the market portfolio, σim . This mean that securities with
larger values of σim will be viewed by investors as contributing more to the risk of the
market portfolio. It also means that securities with larger standard deviations should not
be viewed as necessarily adding more risk to the market portfolio than those securities
with smaller deviations.

From this analysis it follows that securities with larger values for have to provide
proportionately larger expected returns to interest investors in purchasing them. To see
why consider what would happen if such securities did not provide investors with
proportionately larger levels of expected return. In this situation, these securities would
contribute to the risk of the market portfolio. This means that deleting such securities
from the market portfolio would cause the expected return of the market portfolio relative
to its standard deviation to rise. Because investors would view this as a favorable change,
the market portfolio would no longer be the optimal risky portfolio to hold. Thus security
prices would be out of equilibrium.

The exact form of the equilibrium relationship between risk and return can be
written as follows:
rm - r f
ri = rf + ---------- σ iM 6
σ 2M

As you can see in panel (a) of Figure A, Equation 6 represents a straight line having a
vertical intercept of rf and a slope of [(rm – rf ) σ2 m /]. As the slope is positive, the
equation indicates that securities with larger covariance with the market (σim) will be
prices so as to have larger expected returns (ri). This relationship between covariance and
expected return is known as the Security Market Line (SML).
Interestingly, a risky security with σim = 0 will have an expected return equal to
the rate on the riskfree security, rf. Why? Because this risky security, just like the riskfree
security, does not contribute to the risk of the market portfolio. This is so even though the
risky has a positive standard deviation whereas the riskfree security deviation of zero.

Figure A

The Security Market Line


It is even possible for some risky securities (meaning securities with positive
standard deviations) to have expected returns less than the risk free rate. According to the
CAPM, this will occur if σim < 0, thereby indicating that they contribute a negative
amount of risk to the market portfolio to be lower than it would be if less money cause
the risk of the market portfolio to be lower than it would be if less money were invested
in them).
Also of interest is the observation that a risky security with σim = σ2 im will have
an expected return equal to the expected return on the market portfolio rm, This is because
such a security contributes an average amount of risk to the market portfolio.
Another way of expressing the SM is follows;
ri = rf + (rM – rf ) βiM 7
where the term is defined as:

σiM
βiM = ---------- 8
σ2M

The term is known as the beta coefficient (or simply the beta) for security i, and is an
alternative way of representing the covariance of a security. Equation 7 is a different
version of the SML as can be seen in panel (b) of Figure A. Although having the same
intercept as the earlier version shown in Equation (6). rf, it has a different slope. The
slope of this version is (rm - rf), whereas the slope of the earlier version was [(rm - rf )/
σ2m].
One property of beta is that the beta of a portfolio is simply a weighted average of
the betas of its component securities, where the proportions invested in the securities are
the respective weights. That is, the beta of a portfolio can be calculated as:

βpM = Σ Xi βiM (9)


i=1

Earlier it was shown that the expected return of a portfolio is a weighted average
of the expected returns of its component securities, where the proportions invested in the
securities are the weights. This means that because every security plots on the SML, so
will every portfolio. To put it more broadly, not only every security but also every
portfolio must plot on an upward-sloping straight line in a diagram with expected return
on the vertical axis and beta on the horizontal axis. This means that efficient portfolios
plot on both the CML and the SML, although inefficient portfolios plot on the SML, but
below the CML.

Also of interest is that the SML must go through the point representing the market
portfolio itself. Its beta is 1 and its expected return is rm, so its co-ordinates are (1, rm ).
Because riskfree securities have beta value of 0, the SML will also go through a point
with an expected return of rf and coordinates of (0, rf). This means that the SML will have
a vertical intercept equal to rf and a slope equal to the vertical distance between these two
points(rm - rf) divided by the horizontal distance between these two points (1 – 0) or (rm -
rf)/(1 – 0) = (rm - rf). Thus these two points suffice to fix the location of the SML,
indicating the appropriate expected returns for securities and portfolios with different
beta values.

The equilibrium relationship shown by the SML comes to exist through the
pressures on security prices. Given a set of security prices, investors calculate expected
returns and covariance and then determine their optimal portfolios. If the number of
shares of a security collectively desired differs from the number available, there will be
upward or downward pressure on its price. Given a new set of prices, investors will
reassess their desires for the variances securities. The process will continue until the
number of shares collectively desired for each security the number available.

For the individual investor, security prices and prospects are fixed while the
quantities are fixed (at least in the short run), and prices are variable. As in any
competitive market, equilibrium requires the adjustment of each security’s price until
there is consistency between the quantity desired and the quantity available.

It may seem logical to examine historical returns on securities to determine


whether or not securities have been priced in equilibrium as suggested by the CAPM.
However, the issue of whether or not such testing of the CAPM can be done in a
meaningful manner is controversial. For at least some purposes, affirmative test results
may not be necessary to make practical use of the CAPM.

An Example is as follows:
If you refer the example in the last lesson, just try to recall, Able, Baker, and Charlie
were shown to form the market portfolio in proportions equal to .12, .19 and .69
respectively. Given these proportions, the market portfolio was shown to have an
expected return 22.4% and a standard deviation 15.2%. The risk free rate in the example
was 4%. Thus for this example the SML, as indicated in Equation (6) is:
rm - r f (6)
ri = rf + --------- σim
σ2m
22.4 – 4
= 4 + ----------- σim
(15.2)2

= 4 + .08 σim (10)

The following expected return vector and variance covariance matrix can be used
in this examples as:

16.2 146 187 145


ER = 24.6 VC = 187 854 104
22.8 145 104 289

At this point, the co variances of each security with the market portfolio can be calculated
by using Equation (4). More specifically, the co variances with the market portfolio for
Able, Baker, and Charlie are equal to:
3

σ1M = ΣXJM σ1j


i=1
= (.12 x 146) + (.19 x 187) + (.69 x 145)
= 153
3

σ2M = ΣXJM σ2j


i=1
= (.12 x 187) + (.19 x 854) + (.69 x 104)
= 257
3

σ3M = ΣXJM σ3j


i=1
= (.12 x 145) + (.19 x 104) + (.69 x 289)
= 236.

You just note how the SML as given in Equation (10) states that the expected return for
Able should be equal to 4 + (0.08 x 153) = 16.2%. Similarly, the expected return for
Baker should be 4 + (.08 x 257) = 24.6%, and the expected return for Charlie should be 4
+ (.08 x 236) = 22.8%. Each one of these expected returns corresponds to the respective
value given in the expected return vector.
Alternatively, Equation (8) can be used to calculate the betas for the three
companies. More specifically, the betas for Able, Baker, and Charlie are equal to:
σ1M
β1M = ------
σ2m

153
= -----
(15.2)2
= .66
σ2M
β2M = ------
σ2m

257
= -----
(15.2)2
= 1.11
σ3M
β3M = ------
σ2m

236
= -----
(15.2)2
= 1.02.

Now equation (7) indicated that the SML could be expressed in a form where the
measure of risk for an asset was its beta. For the example under consideration, this
reduces to:
ri = rf + (rM-rf) βiM
= 4 + (22.4 – 4) βiM
= 4 + 18.48 βiM (11)
Note how the SML as given in this equation states that the expected return for Able
should be equal to 4 + (18.4 x .66) = 16.2%. Similarly, the expected return for Baker
should be 4 + ( 18.4 x 1.11) = 24.6%, and the expected return for Charlie should be 4 +
(18.4 x 1.02) = 22.8%. Each one of these expected returns correspond to the respective
value given in the expected return vector.
It is important to realize that if any other portfolio is assumed to be the market
portfolio, meaning that if any set of proportions other than .12, .19 and .69 is used, then
such an equilibrium relationship between expected returns and betas (or covariance) will
not hold. Consider a hypothetical market portfolio with equal proportions (that is, .333)
invested in Able, Baker and Charlie. Because this portfolio has an expected return of
21.2% and a standard deviation of 15.5%, the hypothetical SML would be as follows:
rm - r f
ri = rf + --------- σiM
σ2m
21.2 - 4
= 4 + ----------- σiM
(15.5)2
= 4 + .07 σiM.

Able has a covariance with this portfolio of :

σ1m = ΣX jM σ1j
j=1

= (.333 x 146) + (.333 x 187) + (.333 x 145)


= 159,

which means that Able’s expected return according to the hypothetical SML should be
equal to 15.1% = 4 + (0.70 x 159). However because this does not correspond to the
16.2% figure that appears in the expected return vector, a portfolio with equal proportions
invested in Able, Baker, and Charlie cannot be the market portfolio.

THE MARKET MODEL

Market model assumes the return on a common stock was to be related to the return on a
market index in the following manner.
ri = αiI + βiI rI + ∈iI (1)

Where ri = return on security for some given period,


rI = return on market index for the same period,
αiI = intercept term,
βiI = slope term,
∈iI = random error term.

It is but natural to think about the relationship between the market model and the Capital
Asset Pricing Model. After all, both models have a slope term called “beta” in them, and
both models somehow involve the market. However, there are two significant differences
between the models.

First, the market model is a factor model, or to be more specific, a single-factor


model where the factor is a market index. Unlike the CAPM, however, it is not an
equilibrium model that describes how prices are set for securities.

Second, the market model utilizes a market index such as the S$P 500, where as
the CAPM involves the market portfolio. The market portfolio is a collection of all the
securities in the marketplace, whereas a market index is in fact based on a sample of the
market broadly construct (for example, 500 in the case of the S&P 500). Therefore,
conceptually the beta of a stock based on the market model, βiI, differs from the beta of
the stock according to the CAPM, βiM. This is because the market model beta is measured
relative to a market index while the CAPM beta is measured relative to the market
portfolio. In practice, however, the composition of the market portfolio is not precisely
known, so a market index is used. Thus while conceptually different, betas determined
with the use of a market index are treated as if they were determined with the use of the
market portfolio. That is, βiI is used as an estimate of βiM.

In the example, only three securities were in existence – the common stocks of
Able, Baker, and Charlie. Subsequent analysis indicated that the CAPM market portfolio
consisted of these stocks in the proportions of .12, .19 and .69, respectively. It is against
this portfolio that the betas of the securities should be measured. However, in practice
they are like to be measured against a market index (for example, one that is based on just
the stocks of Able and Charlie in proportions of .20 and .80 respectively).

Market Indices
One of the most widely known indices is the Standard & Poor’s Stock Price Index
(referred to earlier as the S&P 500), a value-weighted average price of 500 large stocks.
Complete coverage of the stocks listed on the New York Stock Exchange is provided by
the NYSE. Composite Index, which is broader than the S&P 500 in that it considers more
stocks. The American Stock Exchange computes a similar index for the stocks it lists, and
the National Association of Security Dealers provides an index of over-the-counter stocks
traded on the Nasdaq system. The Russell 3000 and Wilshire 5000 stock indices are the
most comprehensive indices of U.S. common stock prices published regularly in the
United States. Because they consist of both listed and over-the-counter stocks, they are
closer than the others to representing the overall performance of American stocks.

Without question the most widely quoted market index is the Dow Jones Industrial
Average (DJIA). Although based on the performance of only 30 stocks and utilizing a
less satisfactory averaging procedure, the DJIA provides at least a fair idea of what is
happening to stock prices. Table 10.1 provides a listing of the 30 stocks whose prices
have been reflected in the DJIA.

Market and Non-Market Risk


The total risk of a security could be partitioned into two components as follows –
σ2i = β2i1 σ21 + σ2εi (2)
where the components are:

β2 σ2 = market risk, and


σ2 = unique risk.
Because beta, or covariance, is the relevant measure of risk for a security
according to the CAPM, it is only appropriate to explore the relationship between it and
the total risk of the security. It turns out that the relationship is identical to that given in
Equation (2) except that the market portfolio is involved instead of a market index.

σ2i = β2iM σ2I + σ2εi (3)

As with the market model, the total risk of security i, measured by its variance and
denoted σ2i, is shown to consist of two parts. The first component is the portion related to
moves of the market portfolio. It is equal to the product of the square of the beta of the
stock and the variance of the market portfolio, and also often referred to as the market
risk of the security. The second component is the portion not related to moves of the
market portfolio. It is denoted σ2 ∈i and can be considered non-market risk. Under the
assumptions of the market model, it is unique to the security in question and hence is
termed unique risk. Note that if is treated as an estimate of βim , then the decomposition
of σ2i is the same in equation (2) and (3).

An Example

From the earlier example, the betas of Able, Baker, an Charlie were calculated to be .66,
1.11 and 1.02, respectively. As the standard deviation of the market portfolio was equal
to 15.2%, this means that the material risk of the three firms is equal to (.662 x 15.22) =
100, (1.112 x 15.22) = 285, and (1.022 x 15.22) = 240, respectively.
The non-market risk of any security can be calculated by solving equation (3) for
σ2 ∈i

σ2∈i = σ2i - β2iM σ2M (4)

Thus, Equation (10.13) can be used to calculate the non-market risk of Able, Baker,
and Charlie, respectively,

σ2∈1 = 146 – 100


= 46
σ2∈2 = 854 – 285
= 569
σ2∈3 = 289 – 240
= 49.

Non-market risk is sometimes expressed as a standard deviation. This is calculated by


taking the square root of σ2 ∈i and would be equal to √46 = 6.8% for Able, √568= 23.9%
for Baker, and √49=7% for Charlie.

Motivation for the Partitioning of Risk

At this point one may wonder: why partition total risk into two parts? For the investor, it
would seem that risk is risk- whatever its source. The answer lies in the domain of
expected returns.

Market risk is related to the risk of the market portfolios and to the beta of the
security in question. Securities with larger betas will have larger amounts of market risk.
In the world of the CAPM, securities with larger betas will have larger expected returns.
These two relationships together imply that securities with larger market risks should
have larger expected returns.

Non-market risk is not related to beta. This means that there is no reason why
securities with larger amounts of non-market risks should have larger expected returns.
Thus according to the CAPM, investors are awarded for bearing market but not bearing
non-market risk. You try to solve the following problems and questions.
QUESTIONS AND PROBLEMS
1. Describe the key assumptions underlying the CAPM.
2. Many of the underlying assumptions of the CAPM violated to some degree in the
“real world”. Does the fact invalidate the model’s conclusions? Explain.
3. What is the separation theorem? What implications does it have for the optimal
portfolio of risky assets held by investors?
4. What constitutes the market portfolio? What problems does one confront in
specifying the composition of the true market portfolio? How have researchers
and practitioners circumvented these problems?
5. In the equilibrium world of the CAPM, is it possible for a security not to be part
of the market portfolio? Explain.
6. Describe the price adjustment process that equilibrates the market’s supply and
demand for securities. What conditions will prevail under such an equilibrium?
7. Will an investor who owns the market portfolio have to buy and sell units of the
component securities every time the relative prices of those securities change?
Why?
8. Given an expected return of 12% for the market portfolio, a riskfree rate of 6%,
and a market portfolio standard deviation of 20%, draw the Capital Market Line.
9. Explain the significance of the Capital Market Line.
10. Assume that two securities constitute the market portfolio. Those securities have
the following expected returns, standard deviations, and proportions:

Expected Standard
Security Return Deviation Proportion
A 10% 20% 40
B 15 28 60
Based on this information, and given a correlation of .30 between the two securities and
riskfree rate of 5%, specify the equation for the Capital Market Line.
11. Distinguish between the Capital Market Line and the Security Market Line.
12. The market portfolio is assumed to be composed of four securities. Their
covariances with the market and their proportions are shown below:
Covariance
Security with market Proportion
A 242 .20
B 360 .30
C 155 .20
D 210 .30
Given this data, calculate the market portfolio’s standard deviation.
13. Explain the significance of the slope of the SML. How might the slope of the
SML change over time?
14. Why should the expected return for a security be directly related to the security’s
covariance with the market portfolio?
15. The risk of a well-diversified portfolio to an investor is measured by the standard
deviation of the portfolio’s returns. Why shouldn’t the risk of an individual
security be calculated in the same manner?
16. A security with a high standard deviation of returns is not necessarily highly risky
to an investor. Why might you suspect that securities with above-average standard
deviations tend to have above-average betas?
17. Oil Smith, an investments student, argued, “A security with a positive standard
deviation must have an expected return greater than the riskfree rate. Otherwise,
why would anyone be willing to hold the security?” Based on the CAPM, is Oil’s
statement correct? Why?
18. Kitty Bransfield owns a portfolio composed of three securities. The betas of those
securities and their proportions in Kitty’s portfolio are shown on the next page.
What is the beta of Kitty’s portfolio?
Security Beta Proportion
A .90 .30
B 1.30 .10
C 1.05 .60
19. Assume that the expected return on the market portfolio is 15% and its standard
deviation is 21%. The riskfree rate is 7%. What is the standard deviation is 2%.
The riskfree rate is 7%.What is the standard deviation of a well-diversified (no
non-market-risk) portfolio with an expected return of 16.6%?
20. Given that the expected return on the market portfolio is 10%, the riskfree rate of
return is 6%, the beta of stock A is .85, and the beta of stock B is 1.20:
a. Draw the SML.
b. What is the equation for the SML?
c. What are the equilibrium expected returns for stocks A and B?
d. Plot the two risky securities on the SML?
21. You are given the following information on two securities, the market portfolio,
and the riskfree rate:

Correlation
Expected with market Standard
Return Portfolio Deviation
Security 1 15.5% 0.90 20.0%
Security 2 9.2 0.80 9.0
Market Portfolio 12.0 1.00 12.0
Riskfree Rate 5.0 0.00 0.0
a. Draw the SML.
b. What are the betas of two securities?
c. Plot the two securities on the SML?
22. The SML describes an equilibrium relationship between risk and expected return.
Would you consider a security that plotted above the SML to be an attractive
investment? Why?
23. Assume that two securities, A and B, constitute the market portfolio. Their
proportions and variances are .39, 160, and .61, 340, respectively. The covariance
of the two securities is 190. Calculate the betas of two securities.
24. The CAPM permits the standard deviation of a security to be segmented into
market and non-market risk. Distinguish between the two types of risk.
25. Is an investor who owns any portfolio of risky assets other than the market
portfolio exposed to some non-market risk? Explain.
26. Based on the risk and return relationship of the CAPM, supply values for the
seven missing data in the following table.
Expected Standard Non-market
Security Return Beta Deviation Risk (σ2 ∈i )
A ______% 0.8 _______% 81
B 19.0 1.5 _______ 36
C 15.0 ____ 12 0
D 7.0 0 8 _______
E 16.6 _____ 15 _______

27. (Appendix Question) Describe how the SML is altered when the riskfree
borrowing rate exceeds the riskfree lending rate.