Introduction
Assets like trade and bonds in the capital market are the most important aspects of finance and investment. The central issues presented in studying assets are determining the value of the assets. The cost is derived by examining the market value of the asset and its pecuniary resources in the future together with the risk attached to this resources. For investors, it is important to examine the value of an asset and the return of risk as well. The security market line is designed for this purpose (Gitman, 2015).
What is more, determination of an asset more natural as it either rises or falls when plotted in a graph. The security market equation outlines that the return of a specific investment is equal to a market risk premium plus the risk-free rate multiplied by the investment’s beta (Gitman, 2015). This paper discusses the principles and uses of the security market line and beta in managing the return on individual asset. It also develops differences between the two and determines the interaction they have in determining the return on an asset. The final part of the paper discusses the principles might work together.
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Principles of the Security Market Line and Beta
The Security Market Line
It is designed to measure the expected value of return of a particular asset, the security market line is presented graphically to depict the capital pricing model and its relation with assets. According to Dastidar ( 2017), at a certain given period, a non-diversifiable asset identified by beta is plotted by the Security Market line against the return received from the market to determine the rate of return.
For marketable securities and bonds, the same method can be applied to show the extent of risk. The presentation of its equation is stated as follows ;
Security Market Line (SML)= E(Ri ) = Rf +βi [E(RM) – Rf ]
On observation, when the plot drawn on the graph falls above the security market line, this is an undervalue. An investor who finds this should expect higher returns on the investment chosen. On the other hand, an overvalue occurs when individual security is plotted on the security market line and rises beyond the line. The expected return for this case is low, and therefore an Investor should not expect much.
Beta
It’s a statistical measure of the volatility of an investment on the action of the market. Identified as a crucial component of the Capital Asset Pricing Model(CAPM), it majorly calculates the cost of equity. The market is considered primarily to have a beta of 1.0 giving a basis of how individual stocks are ranked in the market. High beta stocks are listed high than the beta value, they are riskier but promise high value of returns that low beta stocks. A beta that falls on the 0 value categorically falls nowhere in the market and remains independent. Beta coefficient of stock is presented as;
β =Cov(rs rm)
o2 m where rs Stock return
rm Market return
o2 m Market variance
Differences between Security Market Line and Beta
While the security market line plots expected returns on investment with consideration of its market risk, Beta determines and shows the risk associated with the investment in the current portfolio. Beta also compares return risk on the stock.
The two principles interact mutually to give an expected return of an asset/ The security market line rises with the beta to give a final position. It starts at 0 where there are little or no risk rate and advances to the market value of beta or below. The security market line can relatively stop at the 0 value indicating independence of the stock. It shows a positive linear relationship between returns and risks as measured by beta (Gitman, 2015)
An example of how the principles are used to manage asset returns is; by examining Microsoft’s earnings in the last two years; The Company’s revenues were $3.12 per share. The financial records also showed an expected growth rate of 10 %. Using the formula, this will be computed as;
$ 3.12 (1+10)
.1688 -.10 = $ 49.88 As the asset return plotted on the Security Market Line.
These two principles and a Christian worldview might work together in harmonizing the market to standard rules which are derived from measures of risks to understand trends and investment opportunities.
Conclusion
The essentials of risk and return have been adequately analyzed in the principles of security market line and Beta. The Security market line is most important because it outlines the rewards that are given to financial markets for bearing risk. Besides Beta identifies the uncertainty in the current investment which helps investors in analyzing the value of returns.
References
Dastidar, S. G. (2017). Capital Markets and Investments (1 ed.). New York: Reading Light publications.
Lawrence J Gitman, R. J. (2015). Principles of Managerial Finance (6 ed.). Australia: Pearson Higher Education AU. Retrieved May 20, 2015
