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Apply the security market line to spot assets that are mispriced

CFA® Level I · Portfolio Construction · Portfolio Risk and Return: Part II · PM.4.d

The idea

The security market line plots required return against beta, and under the CAPM every correctly priced asset lies on it. An asset whose expected return plots above the line offers more than its systematic risk warrants and is undervalued. One below the line is overvalued. The vertical distance between an asset's expected return and the line is its alpha. The test is only as good as the expected return estimate, so a plot far above the line usually means the forecast is wrong rather than that the market has left money on the table.

Formulas

Alpha against the security market line

α = expected return − required return

expected return
the return the analyst forecasts for the asset
required return
what the capital asset pricing model says it should return for its beta
α
the difference between them

Positive alpha plots above the security market line and the asset is underpriced; negative plots below and it is overpriced. It is only ever as good as the forecast, which is why two analysts get two alphas for the same share.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does the security market line plot?

  1. Required return against beta - correct
  2. Expected return against standard deviationWhy not: That is the capital allocation or capital market line, which uses total risk on its horizontal axis.
  3. Excess return against tracking errorWhy not: Compares an active portfolio's extra return with its risk relative to a benchmark. It is not the security market line.

The security market line is a straight line showing the return the CAPM says an asset should earn for its beta. Required return = Risk-free rate + Beta x Market risk premium. Beta is on the horizontal axis and required return on the vertical axis. If every asset is fairly priced, each one sits on this line. The line that plots expected return against total risk (standard deviation) is a different one, the capital market line.

A harder one

An asset plots below the security market line. What does that indicate?

  1. It is undervaluedWhy not: Undervalued assets plot above the line, offering more than their beta demands.
  2. It is correctly pricedWhy not: Correct pricing puts the asset exactly on the line.
  3. It is overvalued - correct

The security market line shows the return the CAPM says an asset needs for its level of market risk: Required return = Risk-free rate + Beta x Market risk premium. An asset below the line is expected to earn less than that required return. It is being paid too little for the risk it carries, so its price is too high, which means it is overvalued. Assets above the line offer more than they need to and are undervalued. Assets on the line are fairly priced.

The hardest tier

A security's CAPM alpha is calculated as +6% a year. Why should the analyst be sceptical before acting on it?

  1. Because a positive alpha indicates the security is overvalued by the marketWhy not: A positive alpha means the expected return is above the required return, so the security looks undervalued, not overvalued.
  2. Because the CAPM is designed for portfolios, not individual securitiesWhy not: It is applied to individual securities routinely, which is why alpha is calculated for them.
  3. Because expected return is only an estimate, so the alpha may be forecast error - correct

Alpha is the extra return a security is expected to earn beyond what its risk requires. Alpha = Expected return - Required return. The required return comes from the CAPM, but the expected return is only a forecast, not a fact. A +6% alpha would mean the market has badly mispriced the security, and a forecasting error is more likely than that. Example: if the analyst's forecast is 3 percentage points too high, half the alpha disappears. So test the inputs before acting.

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