Question

1. Describe and illustrate the expected relationship between risk and expected return based on security market line (SML)
3. Hwang DBS Bhd has identified three potential stocks to buy in FBM KLCU but will only pick two to be added in the portfolio. The following information has been collected:

4. 	AirAsia	Daya Material	Muhibbah Engineering
   Expected return	12%	25%	18%
   Standard deviation of return	2.2	5.9	3.4

   Covariances of returns between companies
   AirAsia and Daya Material	8.2
   AirAsia and Muhibbah Engineering	2.5
   Daya Material and Muhibbah Engineering	17.6

   (i)Estimate the correlation coefficients between each of the three possible portfolio combinations and explain the implications of these coefficients for portfolio risk.

   (ii)Calculate the expected rate of return and standard deviation for each of the three possible 2-stock portfolios, and indicate which portfolio has the most efficient risk-return profile.

Answer 1

Risk : Risk of security is defined as variation of actual return from expected return. The uncertainty of actual return is risk.

SML: Security Market Line (SML) is regression between Beta of security and return of security.

SML represents the CAPM equation and implies a linear connection between the expected return and systematic risk (Beta). The SML intercept on the Y-axis (expected returns) represents the risk free rate when beta equals to 0. CAPM indicates that the market portfolio is efficient, thus all stocks should lie on the SML.

Shares should be bought if the security is plotted above the SML as it is undervalued there and investors can expect good return.

Similarly, share should be sold if it is plotted below the line as it indicate it is overvalued.

Therefore we can conclude that all shares should be be lie on Security Market Line as all these are efficient portfolio.

On SML risk reward reward ratio is favorable.

RR = Rf+Beta (Rm-Rf)

Where

RR = Required Return

RF = Risk Free Security

Rm = Market Return

RR = Required Return

If ER > RR under priced, One Should Invest

If ER< RR overpriced  , One should sold the security

If ER = RR Correctly Priced