Investments, tenth edition

  The Security Market Line 

 We can view the expected return–beta relationship as a reward–risk equation. The beta of 

a security is the appropriate measure of its risk because beta is proportional to the risk the 

security contributes to the optimal risky portfolio. 

 Risk-averse investors measure the risk of the optimal risky portfolio by its variance. 

Hence, we would expect the risk premium on individual assets to depend on the  contribu-

tion  of the asset to the risk of the portfolio. The beta of a stock measures its contribution to 

the variance of the market portfolio and therefore the required risk premium is a function 

of beta. The CAPM confirms this intuition, stating further that the security’s risk premium 

is directly proportional to both the beta and the risk premium of the market portfolio; that 

is, the risk premium equals  b [ E ( r

M

 )  2 r

f

 ]. 

 The expected return–beta relationship can be portrayed graphically as the    security