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TeachMeFinance.com
The Security Market Line
The formula for CAPM is Ks
= Krf + B ( Km - Krf).
Let's assume that the risk free rate is
5%, and the overall stock market will produce a rate of
return of 12.5% next year. You see that XYZ company (Read
our disclaimer) has a beta of 1.7
I f you make a graph of this situation, it would look like this:
- On the horizontal axis are the betas of all companies in the market
- On the vertical axis are the required rates of return, as a percentage
The red line is the Security Market Line.
How did we get it? We plugged in a few
sample betas into the equation
Ks = Krf +
B ( Km - Krf).
| Security | Beta (measures risk) | Rate of Return |
| 'Risk Free' | 0.0 | 5.00% |
| Overall Stock Market | 1.0 | 12.50% |
| XYZ Company | 1.7 | 17.75% |
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