ABC Company’s stock earned a return of 10% this past year. Investors’ required return for this stock based on the SML equation was 9%. Where would this stock plot on the SML? What can you say about this investment’s alpha? Explain.

The Security Market Line (SML) is used to depict the relationship between an asset's return and the risk associated with it. The SML may be expressed as an equation:

Re = Rf + ß (Rm - Rf) where Re is the required return, Rm is the return in the market, Rf is the risk free rate, ß is the beta coefficient which measures the rate at which the stock's return must change as a result of changes in systematic risk (risk inherent in the market as a whole)

In ABC's case, the required return on the stock has already been computed as 9%. Given the level of risk, 10% exceeds the required return of 9% meaning that the stock would place above the SML.

Alpha is the result of a calculation that is done to determine the highest return associated with the least amount of risk. It is the difference between the actual return and the required return. It represents the value that an investment manager creates to a portfolio, hence quantifying the value added by an active investment strategy. In ABC's case, the stock's alpha is equal to +1%. This means that the investment performed 1% better than the broader market.

andromache andromache · Answer 2 · 2022-02-01T14:12:22+01:00

ABC's stock would be above the SML.

The investment's alpha is positive.

Security market line:

The Security Market Line (SML) is used to represent the relationship between an return of the asset and the risk associated with it. Given the level of risk, 10% exceeds the required return of 9% thsi represent that the stock would place above the SML. It is the difference between the actual return and the required return. In ABC's case, the stock's alpha is equal to +1%.

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