Wednesday, May 20, 2009

Asset Pricing Models, Pt 3 - SML

Asset Pricing Models [ 1 - 2 - 3 ]

The Security Market Line (SML) uses CAPM to determine if securities are relatively over or under valued as compared to the market portfolio.

The SML is a graph where the Y axis is expected return, E(R), and the X axis is systematic risk, β. The two points used to construct the line are when β = 0 at RFR and β = 1 at E (R mkt). The line is extended beyond β=1 and individual securities are superimposed as a scatter plot on the graph.
This line represents portfolios which are appropriately valued given their systematic risk relative to the market portfolio. Therefore, portfolios or securities that lie above the line have excessive returns (are undervalued) and securities that lie below the line have under performing returns (not enough returns for the given systematic risk, overvalued).

Notice in the example above:
Security A, Above SML, excess returns, undervalued - Decision: Buy
Security B, Below SML, underperforming returns, overvalued - Decision: Sell
Security C, At SML, equilibrium returns, appropriately valued - Decision: Hold

Using the SML helps identify securities which are mispriced so that the appropriate action can be taken.

Asset Pricing Models [ 1 - 2 - 3 ]

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