Security Market Line
The security market line is a graphic illustration of the capital asset
pricing model that depicts the risk/return relationship of a security.
Figure 12–4 plots the security market line for the stock with a beta
coefficient of 2 used in the example in the preceding section. With a
beta coefficient of 0, the required rate of return is the risk-free rate
of 3.5 percent. With a beta coefficient of 1, the required rate of return
is 8 percent (the same as the market rate of return), and a beta coefficient
of 2 for this security results in a required rate of return of 12.5
percent. The security market line for this stock shows that as the
beta (risk) increases, so does the required rate of return.
The key to this model is that in a rising market, people investing
in stocks with higher beta coefficients than those of the market
should increase their potential returns; in a down market, to minimize
their potential losses, investors should invest in stocks with beta
coefficient, that are lower than those of the market.
Security Market Line for Stock with a Beta Coefficient of 2
Use of the beta coefficient provides insight into the relationship
between the nondiversifiable risk of stocks and their returns.
However, beta coefficients are derived from past price movements,
which often have no bearing on future price movements. Despite
its enthusiastic adoption by Wall Street when the CAPM was introduced
in 1964, the model has been under attack by academicians.
Studies done to test the validity of the CAPM were not supportive.
Astudy done by two professors, Eugene Fama and Kenneth French
(1992), which also turned upside down the axiom “The greater the
risk, the greater the return,” taught in finance classes, showed that
the beta coefficient did not explain the differences in returns on
stocks. In their study, these authors grouped stocks into portfolios
based on market capitalization (size), and there was a relationship
between the size of the companies and their beta coefficients, even
though there was a wide range of the latter. However, when stocks
were grouped on the basis of size and beta coefficients, a good
relationship to returns was not found.
According to Malkiel (1990, pp. 243–255), studies done to test
the validity of the CAPM showed the following:
* There was some unsystematic risk that caused zero-beta
securities to have higher returns. In other words, the security
market line (SML) was too flat compared with the prediction
from the CAPM.
* The risk/return relationship turned out to be different from
that of the CAPM. Low-risk stocks earned returns higher
than expected, and high-risk stocks earned returns lower
* For shorter-term periods, there were deviations from the
relationships predicted by the CAPM.
* There was a problem estimating beta coefficients based on
past sensitivity to the market. These relationships change,
and there are other factors that need to be considered in
determining the beta coefficient.
There is no perfect measure of risk, but the CAPM provides a
framework to assess the relationship between the risk and return of
Categories in Trading Mistakes
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Failure to control Risk
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Lack of Discipline
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