Hope the preps are going good! Can anyone please help on security market line ?? Schweser notes say that the market risk premium is the additional return that the investors require for bearing systematic risk I.e. beta. however, since we assume that the portfolio is a market portfolio and thus market risk premium is going to be same for all the levels of beta/return combinations on SML and the only thing that makes the slope positively upward sloping is the beta that changes for different levels of required return/expected return. Not able to understand how they say that the slope is the E(Rp) minus Rf. Confused !
Please help on the above. Thanks a ton in advance !
The SML is simply a graphical version of the CAPM according to which E(Rp)=rf + Beta (Market risk premium). The SML plots Beta on the x-axis and E(Rp) on the y-axis and given the linear nature of the model, (Market risk premium) becomes the slope in the same way as (b) is the slope for the following general linear function :y=a+b*x.
The (market risk premium) is simply the difference between the Expected return on the market and the risk free rate or E(Rm)-rf.
Clearly,if you are invested in a portfolio that has zero beta, the return you would expect is rf. For any portfolio that has a beta greater than zero, you will be compensated above the rf depending on that portfolios beta or systematic risk.
You said ‘we assume the portfolio is a market portfolio’…we assume this for the E(Rm) not necessarily for the E(Rp) which can be anything you like including but not limited to the market portfolio. If you are invested in the market portfolio for example, then E(Rp)=E(Rm)=rf+beta(E(Rm)-rf). Since the beta of the market portfolio is equal to 1 then it follows that the risk free rates cross out and we are left with E(Rp)=E(Rm)