Principles of Managerial Finance

240 PART 2 Important Financial Concepts

21. Because RFis the rate of return on a risk-free asset, the beta associated with the risk-free asset, bRF, would equal


22. The 0 beta on the risk-free asset reflects not only its absence of risk but also that the asset’s return is unaffected by
    movements in the market return.

Required Return,

k

(%)

17

16

15

14

kz = 13

12

km = 11

10

9

8

RF = 7

6 5 4 3 2 1

0 .5 1.0 1.5 2.0

Market

Risk

Premium

(4%)

Asset Z’s

Risk

Premium

(6%)

SML

bRF bm bz

Nondiversifiable Risk, b

FIGURE 5.10

Security Market Line
Security market line (SML)
with Benjamin Corporation’s
asset Z data shown

security market line (SML)
The depiction of the capital
asset pricing model (CAPM) as a
graph that reflects the required
return in the marketplace for
each level of nondiversifiable
risk (beta).

The Graph: The Security Market Line (SML)

When the capital asset pricing model (Equation 5.8) is depicted graphically, it is

called the security market line (SML).The SML will, in fact, be a straight line. It

reflects the required return in the marketplace for each level of nondiversifiable

risk (beta). In the graph, risk as measured by beta, b,is plotted on the xaxis, and

required returns, k,are plotted on the yaxis. The risk–return tradeoff is clearly

represented by the SML.

EXAMPLE In the preceding example for Benjamin Corporation, the risk-free rate, RF,was

7%, and the market return, km,was 11%. The SML can be plotted by using the

two sets of coordinates for the betas associated with RFand km,bRFand bm(that

is, bRF0,^21 RF7%; and bm1.0, km11%). Figure 5.10 presents the result-

ing security market line. As traditionally shown, the security market line in Figure

5.10 presents the required return associated with all positive betas. The market

risk premium of 4% (kmof 11%RFof 7%) has been highlighted. For a beta for

asset Z, bz,of 1.5, its corresponding required return, kz,is 13%. Also shown in

the figure is asset Z’s risk premium of 6% (kzof 13%RFof 7%). It should be

clear that for assets with betas greater than 1, the risk premium is greater than

that for the market; for assets with betas less than 1, the risk premium is less than

that for the market.