Cost of Capital^69
rate of return Rf and km - Rf is the slope of the SML. Since all securities are expected
to plot along the SML, the line provides a direct and convenient way of determining the
expected/required return of a security if we know the Beta of the securities. The SML
can also be used to classify securities. Those with betas greater than 1.00 and plotting
on the upper part of the SML are classified as aggressive securities while those with
betas less than 1.00 and plotting on the lower part of the SML can be classified as
defensive securities which earn below-average returns.
Asset pricing implications of the SML
One of the major assumptions of the CAPM is that the market is in equilibrium and that
the expected rate of return is equal to the required rate of return for a given level of
market risk or beta. In other words, the SML provides a framework for evaluating
whether high-risk stocks are offering returns more or less in proportion to their risk and
vice versa.
Once a security's expected rate of return and beta have been computed they may be
plotted with reference to the SML. If the security's required rate of return , the security
may be over or under priced and may fall below or above the SML.
X
From the figure we see that Rf = 6% and km = 12%.Two securities X and Y have been shown in the figure. Both X and Y should have been
on the SML but obviously are not. Taking the case of X first, the expected rate of
return from X is around 25%. But at a beta of around 1.2, using the SML we see that
the required rate of return need be only around 13%. This tells us that security X is
undervalued or priced too low because its average rate of return is inappropriately high
for the level of risk it bears.
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