The __ is a positively sloped linear function that plots securities’ expected returns against their betas.
A) reward-to-risk matrix B) portfolio weight graph C) normal distribution D) security market line E) market real returns
The correct answer and explanation is:
The correct answer is D) security market line.
The Security Market Line (SML) represents the relationship between the expected return of a security and its systematic risk, as measured by beta. In the context of the Capital Asset Pricing Model (CAPM), the SML is a graphical representation of the market’s risk-return tradeoff. The x-axis of the SML plots the beta of the security, which reflects its sensitivity to market movements, while the y-axis shows the expected return of the security.
The SML is positively sloped, indicating that as the beta (or risk) of a security increases, the expected return also increases. This positive slope reflects the risk-return tradeoff, meaning investors expect a higher return for taking on more risk. The intercept of the SML with the y-axis represents the risk-free rate, the return on a risk-free asset like government bonds. The slope of the line is determined by the market risk premium, which is the difference between the expected market return and the risk-free rate.
For example, if a security has a higher beta, implying that it is more sensitive to market fluctuations, investors will expect a higher return to compensate for the increased risk. On the other hand, a security with a lower beta would be expected to offer a lower return, as it is less risky.
In summary, the Security Market Line is a crucial concept in modern portfolio theory and the CAPM. It helps investors determine whether a security offers an adequate return for its level of systematic risk, thereby aiding in portfolio optimization and decision-making based on risk and return expectations.