I’ve gone over this a ton of times, but always forget what the slope of the CML & SML represent? Please help! Thanks.
The slope of the SML represents the market risk premium. The CML is used to determine if a portfolio is holding more (borrowing) or less (lending) than 100% of the market portfolio.
Ahh, thank you so much!
Could someone also explain why return above SML is underpriced while return below SML is overpriced??
^ yeah. And whoever does the explanation, please do it in clearly and in simple terms. I need to get/understand Portfolio Management.
kosei Wrote: ------------------------------------------------------- > Could someone also explain why return above SML is > underpriced while return below SML is overpriced?? You have the above backwards. Use CAPM to find out if the securities return is greater than or less than the SML. Above = Overpirced (too much risk per return) Below = Underpirced (less risk than SML for same return)
Sure about that? Risk is measured on X axis and return on Y axis. That would indicate that securities plotting above the SML have too much return for that level of risk. As such the price will increase so that return comes back to a level on the SML?
QuantJock_MBA, I think you have it wrong! SML Above = Underpirced Below = Overpirced
Damil4real Wrote: ------------------------------------------------------- > QuantJock_MBA, I think you have it wrong! > > SML > > Above = Underpirced > Below = Overpirced You’re right. I wrote that right when I woke up. Please forgive me. But you simply use the CAPM model to find the expected return with the risk(beta) and compare it to the return on the SML.
I think you should know it this way: 1. All securities plotting on SML are “properly priced” (in Equilibrium) 2. Y axis measures return 3. There is an inverse relationship between return and price You will then come to the following conclusion: All assets above SML have higher return hence lower price ( underpriced) =Buy All assets under SML have lower return hence higher price (overpriced) =Sell
The return you get from the CAPM model is the required return for the security based on its systematic risk exposure (beta). As such the CAPM return plots on the SML. You compare the return from the CAPM (the SML) with the expected return for the security and if the expected return exceeds the required return (from CAPM/SML) the security is undervalued. If your expected return is below the required return then the security is overvalued. The CAPM is the linear equation for the SML. Its essential y=b+mx, where y=required return, b=risk-free rate(y-intercept), m=market risk premium(slope) and x=beta.
The returns above the line are underpriced, because the expected return is above the required return (the return plotting on the SML line) - it is under priced because you require a return on the SML but you are getting a return above the SML. Same for overpriced. You require the return on the line, but you are only getting a return below the line, you are, in a sense, paying more for a return that is less than you require. The pricing happens on the SML line, and the value plots either on, above, or below it.
I didnt see anyone mention it so I will add that the underpriced securities are underpriced because return (on Y axis) = Div/price. Since the return is greater than the market requirement for that amount of risk, investors will buy the security , driving its price up. Since price is a denominator, it will decrease the return until it is on the SML.
So you require/expect a 5% return on a security based on its systematic risk exposure (beta), but you are getting 10% return, and this means the stock is underpriced? I don’t get it.
Think of it this way. If it’s going to return 10%, and it’s priced to return 5%, people will buy it. Because a bunch of people buy it, it’ll raise the price until the expected return is only 5% (due to a larger starting price). For Example, a stock is priced at $20. If it will increase to $22 (10% increase) but is supposed to earn 5% according to CAPM, people will buy it. The price will rise to roughly $21, so that the expected return is (22-21)/21= 5% (roughly). Because the price is $20 instead of the $21 to should be, it is underpriced.
Got it. Thanks!