Security Market Line

The security market line is a graphic illustration of the capital asset pricing model that depicts the risk/return relationship of a security. Figure 12–4 plots the security market line for the stock with a beta coefficient of 2 used in the example in the preceding section. With a beta coefficient of 0, the required rate of return is the risk-free rate of 3.5 percent. With a beta coefficient of 1, the required rate of return is 8 percent (the same as the market rate of return), and a beta coefficient of 2 for this security results in a required rate of return of 12.5 percent. The security market line for this stock shows that as the beta (risk) increases, so does the required rate of return. The key to this model is that in a rising market, people investing in stocks with higher beta coefficients than those of the market should increase their potential returns; in a down market, to minimize their potential losses, investors should invest in stocks with beta coefficient, that are lower than those of the market.

Figure 12-4
Security Market Line for Stock with a Beta Coefficient of 2


Use of the beta coefficient provides insight into the relationship between the nondiversifiable risk of stocks and their returns. However, beta coefficients are derived from past price movements, which often have no bearing on future price movements. Despite its enthusiastic adoption by Wall Street when the CAPM was introduced in 1964, the model has been under attack by academicians. Studies done to test the validity of the CAPM were not supportive. Astudy done by two professors, Eugene Fama and Kenneth French (1992), which also turned upside down the axiom “The greater the risk, the greater the return,” taught in finance classes, showed that the beta coefficient did not explain the differences in returns on stocks. In their study, these authors grouped stocks into portfolios based on market capitalization (size), and there was a relationship between the size of the companies and their beta coefficients, even though there was a wide range of the latter. However, when stocks were grouped on the basis of size and beta coefficients, a good relationship to returns was not found.

According to Malkiel (1990, pp. 243–255), studies done to test the validity of the CAPM showed the following:
* There was some unsystematic risk that caused zero-beta securities to have higher returns. In other words, the security market line (SML) was too flat compared with the prediction from the CAPM.
* The risk/return relationship turned out to be different from that of the CAPM. Low-risk stocks earned returns higher than expected, and high-risk stocks earned returns lower than expected.
* For shorter-term periods, there were deviations from the relationships predicted by the CAPM.
* There was a problem estimating beta coefficients based on past sensitivity to the market. These relationships change, and there are other factors that need to be considered in determining the beta coefficient.

There is no perfect measure of risk, but the CAPM provides a framework to assess the relationship between the risk and return of a security.

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