Security Market Line (SML) and Risky Asset Portfolios

SML and Risky Asset Portfolios

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Question

Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent risky asset portfolios. The SML crosses the y-axis at the point

0.07. The expected market return equals 13.0 percent. Note: The graph is NOT drawn to scale.

Using the graph above and the information provided, determine which of the following statements is TRUE.

Answers

A. Portfolio Y is undervalued.

B. The correct label for the x-axis is total risk.

C. Portfolio X's required return is greater than the market expected return.

D. The expected return (or holding period return) for Portfolio Z equals 14.8%.

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Explanations

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A. B. C. D.

At first, it appears that we are not given the information needed to calculate the holding period, or expected return (beginning price, ending price, or annual dividend). However, we are given the information required to calculate the required return (CAPM) and since Portfolio Z is on the SML, we know that the required return (RR) equals the expected return (ER). So, ER = RR = Rf+ (ERM"" Rf) * Beta = 7.0% + (13.0% - 7.0%) * 1.3 = 14.8%.

The SML plots beta (orsystematic risk) versus expected return, the CML plots total risk (systematic plus unsystematic risk) versus expected return. Portfolio Y is overvalued "" any portfolio located below the SML has an RR > ER and is thus overpriced. Since Portfolio X plots above the SML, it is undervalued and the statement should read, "Portfolio X's required return islessthan the market expected return."

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