Boundless Lecture Slides
Available on the Boundless Teaching Platform
Free to share, print, make copies and changes. Get yours at www.boundless.com
Boundless Teaching
Platform
Boundless empowers educators to engage their students
with affordable, customizable textbooks and intuitive
teaching tools. The free Boundless Teaching Platform
gives educators the ability to customize textbooks in
more than 20 subjects that align to hundreds of popular
titles. Get started by using high quality Boundless books,
or make switching to our platform easier by building from
Boundless content pre-organized to match the assigned
textbook. This platform gives educators the tools they
need to assign readings and assessments, monitor
student activity, and lead their classes with pre-made
teaching resources.
Using Boundless Presentations
The Appendix
The appendix is for you to use to add depth and
breadth to your lectures. You can simply drag and
drop slides from the appendix into the main
presentation to make for a richer lecture
experience.
Get started now at:
http://boundless.com/teaching-platform
Free to edit, share, and copy
Feel free to edit, share, and make as many copies
of the Boundless presentations as you like. We
encourage you to take these presentations and
make them your own.
If you have any questions or problems please email:
educators@boundless.com
Free to share, print, make copies and changes. Get yours at www.boundless.com
About Boundless
Boundless is an innovative technology company making education more affordable and
accessible for students everywhere. The company creates the world’s best open educational
content in 20+ subjects that align to more than 1,000 popular college textbooks. Boundless
integrates learning technology into all its premium books to help students study more efficiently
at a fraction of the cost of traditional textbooks. The company also empowers educators to
engage their students more effectively through customizable books and intuitive teaching tools
as part of the Boundless Teaching Platform. More than 2 million learners access Boundless free
and premium content each month across the company’s wide distribution platforms, including its
website, iOS apps, Kindle books, and iBooks. To get started learning or teaching with
Boundless, visit boundless.com.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return > Understanding the Security Market Line
Understanding the Security Market Line
• Expected Risk and Risk Premium
• Defining the Security Market Line
• Impact of the SML on the Cost of Capital
Free to share, print, make copies and changes. Get yours at www.boundless.com
www.boundless.com/finance?campaign_content=book_192_section_82&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=dir
ect&utm_source=boundless
Introduction to Risk and Return > Understanding the Security Market Line
Expected Risk and Risk Premium
• In return for undertaking risk, investors expect to be compensated in such as a
way as to reasonably reward them.
• Systemic risk is the risk associated with an entire financial system or entire
market. It cannot be diversified away.
• Unsystematic risk is risk to which only specific classes of securities or industries
are vulnerable, and with proper grouping of assets it can be reduced or even
eliminated.
• Beta is a number describing the correlated volatility of an asset in relation to the
volatility of the benchmark that said asset is being compared to -- usually the
Beta
market as expressed in an index.
View on Boundless.com
• The term risk premium refers to the amount by which an asset's expected rate of
return exceeds the risk-free interest rate.
Free to share, print, make copies and changes. Get yours at www.boundless.com
www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/understanding-the-security-market-line82/expected-risk-and-risk-premium-354-
Introduction to Risk and Return > Understanding the Security Market Line
Defining the Security Market Line
• The security market line is the theoretical line on which all capital investments lie.
Investors want higher expected returns for more risk.
• On a graph, the line has risk on its horizontal axis (independent variable) and
expected return on the vertical axis (dependent variable).
• Assuming a linear relationship between risk and return, the assumption is that the
y-intercept is the return on a risk-free investment (the risk free rate), and the slope
is the premium on risk in terms of expected returns.
• Given two investments with the same expected return, investors would always
choose less risk. Someone with opposite preferences might better be called a
gambler.
The equation that defines the security market
line.
View on Boundless.com
Free to share, print, make copies and changes. Get yours at www.boundless.com
www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/understanding-the-security-market-line82/defining-the-security-market-line-355-
Introduction to Risk and Return > Understanding the Security Market Line
Impact of the SML on the Cost of Capital
• The security market line is a hypothetical concept that suggests that investors
require compensation in the form of expected returns for the risk the investment
exposes them to.
• A capital investment below the security market wouldn't be efficiently priced to the
buyer of the investment. A higher return or lower price would be required, both
increasing the cost of capital.
• A capital investment above the security market line wouldn't be efficiently priced
for the seller or whomever raises the capital. A lower return or higher price would
be necessary to justify this cost of capital for the company.
The Security Market Line
View on Boundless.com
Free to share, print, make copies and changes. Get yours at www.boundless.com
www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/understanding-the-security-market-line82/impact-of-the-sml-on-the-cost-of-capital-356-
Appendix
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
Key terms
• beta Average sensitivity of a security's price to overall securities market prices.
• capital asset pricing model In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate
required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk.
• diversifiable risk the potential for loss which can be removed by investing in a variety of assets
• line of credit source of debt extended to a government, business or individual by a bank or other financial institution
• market risk the potential for loss due to movements in prices in a system of exchange
• market risk premium the amount by which expected rate of return of the exchange system exceeds the risk-free interest rate
• Risk free rate Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
• security market line Security market line (SML) is the representation of the capital asset pricing model. It displays the expected
rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).
• treasury bill Treasury bills (or T-Bills) mature in one year or less. They do not pay interest prior to maturity; instead they are sold
at a discount of the par value to create a positive yield to maturity.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
The Security Market Line
This is an example of a security market line graphed. The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and
the slope is the premium that the market charges for risk.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Wikimedia. CC BY http://upload.wikimedia.org/wikipedia/en/d/d9/SecMktLine.png View on Boundless.com
Introduction to Risk and Return
The Security Market Line
The location of a financial instrument above, below, or on the security market line will lead to consequences for a company's cost of capital.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Wikipedia. "SecMktLine." GNU FDL http://en.wikipedia.org/wiki/File:SecMktLine.png View on Boundless.com
Introduction to Risk and Return
The equation that defines the security market line.
Look at the equation and remember that old formula of a line: y = mx + b. In this case it looks rearranged, like y = b + mx, but the real question is what do
the slope and y-intercept actually represent?
Free to share, print, make copies and changes. Get yours at www.boundless.com
Wikipedia. "Security market line." CC BY http://en.wikipedia.org/wiki/Security_market_line View on Boundless.com
Introduction to Risk and Return
Beta
Beta is a measure that relates the rate of return of an asset, ra, with the rate of return of a benchmark, rb.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Wikipedia. "Beta (finance)." GNU FDL http://en.wikipedia.org/wiki/Beta_(finance) View on Boundless.com
Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock's price.
A) The stock's price increased by 2%.
B) The stock's price increased by more than 2%.
C) The stock's price increased by less than 2%.
D) The stock's price decreased by less than 2%.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
A stock has a beta of 0.75 in relation to the Dow Jones Industrial
Index. Today, the Dow Jones increased by 2%. Based on its beta,
predict what happened to the stock's price.
A) The stock's price increased by 2%.
B) The stock's price increased by more than 2%.
C) The stock's price increased by less than 2%.
D) The stock's price decreased by less than 2%.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
Which of the following statements regarding the Security Market
Line (SML) is true?
A) The x-intercept of the SML is equal to the risk-free interest rate.
B) The SML graphs unsystematic risk
C) The slope of the SML is equal to the market risk premium and reflects
the risk-return trade off.
D) All of these answers.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
Introduction to Risk and Return
A company's security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn't an attractive market situation for a potential investor looking
to purchase the security.
B) The security is fairly priced for the amount of expected return.
C) This is not an attractive market situation for the company issuing the
security.
D) All of these answers.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
A company's security is priced above the security market line.
Which of the following statements regarding that security is true?
A) This isn't an attractive market situation for a potential investor looking
to purchase the security.
B) The security is fairly priced for the amount of expected return.
C) This is not an attractive market situation for the company issuing the
security.
D) All of these answers.
Free to share, print, make copies and changes. Get yours at www.boundless.com
Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
Introduction to Risk and Return
Attribution
• Wikipedia. "Security market line." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_line
• Wiktionary. "line of credit." CC BY-SA 3.0 http://en.wiktionary.org/wiki/line+of+credit
• Wikipedia. "Risk premium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_premium
• Wikipedia. "Diversification (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Diversification_(finance)
• Wikipedia. "Market risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Market_risk
• Wiktionary. "beta." CC BY-SA 3.0 http://en.wiktionary.org/wiki/beta
• Wiktionary. "security market line." CC BY-SA 3.0 http://en.wiktionary.org/wiki/security+market+line
• Wikipedia. "Security market line." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_line
• Wikipedia. "Capital asset pricing model." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_asset_pricing_model
• Wikipedia. "capital asset pricing model." CC BY-SA 3.0 http://en.wikipedia.org/wiki/capital%20asset%20pricing%20model
• Wikipedia. "Systemic risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Systemic_risk
• Wikipedia. "Risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk
• Wikipedia. "Security market line." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_line
• Wikipedia. "Risk premium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_premium
• Wikipedia. "Beta (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Beta_(finance)
• Wikipedia. "Risk-free interest rate." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk-free_interest_rate
• Wikipedia. "treasury bill." CC BY-SA 3.0 http://en.wikipedia.org/wiki/treasury%20bill
Free to share, print, make copies and changes. Get yours at www.boundless.com
Introduction to Risk and Return
• Wikipedia. "Risk free rate." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk%20free%20rate
Free to share, print, make copies and changes. Get yours at www.boundless.com