Financial Risk Manager Part 1

Explanation

Undervalued stocks plot above the Security Market Line (SML). Here's why:

Understanding the Security Market Line (SML)

• The SML is a graphical representation of the Capital Asset Pricing Model (CAPM)
• It plots expected return against systematic risk (beta)
• The line represents the equilibrium condition where all securities are fairly priced

Why Undervalued Stocks Plot Above the SML

• Stocks that plot above the SML offer higher returns than what the CAPM would predict given their level of risk
• This indicates they are providing more return for their risk level than what is considered fair or average
• These stocks are attractive investments because they offer superior risk-adjusted returns

Why Other Options Are Incorrect

• Option B (Under the SML): Stocks below the SML are overvalued - they offer lower returns than expected for their risk level
• Option C (Always on the SML): While the SML represents equilibrium, real-world market imperfections mean stocks can deviate from it
• Option D (Valuation cannot be determined): The SML is specifically designed to help determine valuation by comparing actual vs. expected returns

Key Takeaways

• Above SML = Undervalued (good investment opportunity)
• Below SML = Overvalued (poor investment opportunity)
• On SML = Fairly valued (expected return matches risk level)