The value to Corporate Finance of the SML



Table of Contents

Introduction3

Discussion4

Capital Asset pricing Model4

Efficient and Inefficient Market5

The Security Market line6

The Capital Market line7

Limitations of CAPM, SML, and CML9

Significance of Efficient Market Hypothesis9

Relationship between Risk and Return10

Significance of Standard Deviation12

Estimation of Appropriate return on a risky Project14

Role of CAPM and SML in diversifying the risk14

Recommendations15

Conclusion15

References17

The value to Corporate Finance of the SML

Introduction

The Security Market Line is a result of application of capital asset market line and it is used to interpret the bond between risks and expected return factors associated to an asset or security (Phillips, G., n.d.). The risk represents the beta and the market risk premium is estimated by determining the slope of SML. This line of SML indicates the worth and viability of a asset to be included in a portfolio by analyzing its expect return. The results can be evaluated in a way that when securities lie above the SML then these would be considered as underrated securities and indicates that investor require higher return for holding such securities provided the risk appetite. If securities occur below the SML then these are considered as over valued then it indicates that investors require lower return provided the given risk level.

The capital asset pricing model is a traditional method applied by majority of businesses and individuals to quantify the risk on a particular security. It is aimed at determining the relationship between expected return and risk of assets. It allows investors to evaluate the risk level and determine appropriate price for undertaking such risks for all type s of securities. Furthermore, it facilitates investors to value their investment in terms of expected returns. This method categorizes risk into two types i.e. systematic and unsystematic risks, which can be diversified away and which cannot be diversified due to the universal existence of specific risks. The model basically creates strong relationship between higher returns from established markets to higher risk assumed by investors (Burton, J., 1998).

This paper aims at examining the characteristics of Security Market Line, relationship between risk and return, and the significance of SML with respect to fundamental concepts of corporate finance.

Discussion

Capital Asset Pricing Model

The CAPM is used for explaining the association between risk and expected return in order to determine the value of security. The CAPM model emphasizes that investors are compensated for bearing risky securities in form of receiving risk premium and risk free rate. It helps investors in making evaluating and measuring portfolio risks and returns. The formula for calculating return on security or asset is as follow:

Ra = rf + Beta * ( rm - rf )

rf = The risk free rate

rm = The expected rate of market return

Beta = It is measure of non diversifiable risk

(Value Based Management, n.d.)

CAPM is useful for investors in terms of determination of expected return and risks on their portfolio. It helps in establishing fair rate of return in highly regulated companies. It helps in justifying the behavior of investors that follow global market index as their benchmark for ...