Question

According to Professor William Sharpe, the expected return on a single security is equal to:

a simple weighted average

a nonlinear function of systematic risk

a linear function of systematic risk

present value of cash inflows minus the PV of cash outflows.

the HPR

Answer 1

a linear function of systematic risk

According to william sharpe , there is trade off between expected return of a stock and its systematic risk (also called beta). Systematic risk is non diversifiable risk and can not be avoided with diversification. He suggested that there is linear relationship between expected return and beta(systematic risk) and this line called Security market line (SML). For SML, expected return put on Y- axis and Beta on X- axis. It shows there is positive relationship between beta and expected return which as beta increases the expected return of Stock also increases.

Equation for SML-

where,

Rf = risk free return

Rm = Market return

Beta = Systematic risk

E(R) = Expected Return.

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.