Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

(^466) © The McGraw−Hill
Companies, 2002
This result is really not so surprising. What it says is that, for example, if one asset has
twice as much systematic risk as another asset, its risk premium will simply be twice
as large.
Because all of the assets in the market must have the same reward-to-risk ratio, they
all must plot on the same line. This argument is illustrated in Figure 13.3. As shown, As-
sets A and B plot directly on the line and thus have the same reward-to-risk ratio. If an
asset plotted above the line, such as C in Figure 13.3, its price would rise and its ex-
pected return would fall until it plotted exactly on the line. Similarly, if an asset plotted
below the line, such as D in Figure 13.3, its expected return would rise until it too plot-
ted directly on the line.
The arguments we have presented apply to active, competitive, well-functioning
markets. The financial markets, such as the NYSE, best meet these criteria. Other mar-
kets, such as real asset markets, may or may not. For this reason, these concepts are
most useful in examining financial markets. We will thus focus on such markets here.
However, as we discuss in a later section, the information about risk and return gleaned
from financial markets is crucial in evaluating the investments that a corporation makes
in real assets.
438 PART FIVE Risk and Return

FIGURE 13.3

Asset expected

return (E(Ri))

Asset beta

E(RC)

E(RD)

E(RB)

E(RA)

Rf

E (Ri) – Rf

=

The fundamental relationship between beta and expected return is that all assets must

have the same reward-to-risk ratio, [ E(Ri) – Rf]/ (^) i. This means that they would all plot
on the same straight line. Assets A and B are examples of this behavior. Asset C's
expected return is too high; Asset D's is too low.
A
B
C
D
( )
(^) A (^) B (^) C (^) D
(^) i
(^) i
Expected Returns and Systematic Risk
Buy Low, Sell High
An asset is said to be overvaluedif its price is too high given its expected return and risk. Sup-
pose you observe the following situation:
EXAMPLE 13.7