8.9 The Capital Asset Pricing Model and the Security Market Line
At this point, we can visualize the special relationship among the expected return of any asset or portfolio and its beta, the current risk-free rate, and the market risk premium, a term that you will meet shortly. We will first consider three fundamental assumptions to building this relationship, which will end up as a positively sloped line with risk on the x-axis and expected return on the y-axis. This special line is the security market line (SML). Let’s explore the three assumptions behind it:
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There is a basic reward for waiting: the risk-free rate.
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The greater the risk, the greater the expected reward.
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There is a consistent trade-off between risk and reward at all levels ...
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