Answer to Question #6129 in Economics of Enterprise for Lamarcus Streeter

Question

4. Which of the following statements is CORRECT?

a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
b. Portfolio diversification reduces the variability of returns on an individual stock.
c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events.
d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
e. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio.

Answer 1

d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers
can influence their firms' positions on the line by such actions as changing the
firm's capital structure or the type of assets it employs.

The SML graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the
slope of the SML.
The relationship between β and required return is plotted on the security market line (SML) which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is
E(R_m)− R_f. The security market line can be regarded as representing a single-factor model
of the asset price, where Beta is exposure to changes in value of the Market.
The equation of the SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio
offers a reasonable expected return for risk. Individual securities are plotted
on the SML graph. If the security's risk versus expected return is plotted above
the SML, it is undervalued because the investor can expect a greater return for
the inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting a lower return for the amount of risk assumed.