This linear construct shows the relationship between systematic risk and

This linear construct shows the relationship between

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The CAPM is derived from a linear relationship known as the Security Market Line (SML). This linear construct shows the relationship between systematic risk and expected return on all assets in the market. The SML is shown in Figure 4.1 below. It is a straight line joining the risk-free asset (RF) and the market portfolio (M) which is assumed to be fully diversified. The vertical axis denotes expected return while the horizontal axis shows systematic risk as measured by the beta (β) coefficient. E (RI) = RF + βI (E (RM) – RF ) Where, E (RI ) is expected return on security or portfolio i E (RM) is expected return on the market portfolio RF is the risk-free rate of return βI is the measurement of systematic risk of the asset or portfolio concerned. Example: Assume that expected return on the market portfolio is 14% and the risk-free rate is 4%. Assets A and B have β - values of 0.5 and 1.5 respectively. What levels of return are expected for these two assets?. Solutions
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Assets A E (RI) = RF + βI (E (RM) – RF ) = 4% + 0.5 ( 14% - 4%) = 9% Assets B E (RI) = RF + βI (E (RM) – RF ) = 4% + 1.5 (14% - 4%) = 19% The required rate of return for asset B is higher than for asset A since it is a more risky asset.
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