Question

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Explain the usefulness of the Security Market Line in assessing common stock risk. Explain how we use bond rating categories to assess bond risk

Answer 1

The usefulness of the Security Market Line in assessing common stock risk.

The security market line graphs the systematic risk and expected return of the security. In other words it shows the CAPM model graphically. The beta is shown at x axis and return is shown on y axis.

The beta shows the sensitivity of the stock to the market. If the security expected return is below the SML the security is overvalued and vice versa.

Bond rating categories to assess bond risk

Credit rating standards determine the bonds into high yield and investment grade bonds. The credit rating is given to a bond after properly assessing the credibility of the company, The bond with the higher credit rating has lower chance of default.Thus bond ratings assist in assessing risk,