A line that describes the relationship between an individual security’s returns and returns on the market portfolio.
A. characteristic line
B. security market line
C. capital market line
Answer Explanation for Question: A line that describes the relationship between an individual security’s returns and returns on the market portfolio.
A characteristic line is a line formed through regression analysis that summarizes the risk and return of a security. This line is also called the security characteristic line (SCL). A characteristic line is created by plotting the return on a security at various points in time. This chart measures the excess return of a security along the y-axis. The excess return is measured against the risk-free rate of return. The x-axis on the chart indicates how much the market has returned over the risk free rate.
The plots of the security show the company’s performance in relation to the market in general. The regression line derived from the plots will show the excess return and the amount of systematic risk exhibited by the security during the measured period of time. The y-intercept represents the security’s alpha, which is its rate of return in excess of the risk-free rate, which cannot be explained by the market’s specific risks.
In Modern Portfolio Theory (MPT), the alpha represents the rate of return over and above its risk-free return, adjusted for the asset’s relative riskiness. As a result, the slope of the characteristic line represents a security’s systematic risk, or beta, which represents the asset’s price’s correlated variability when compared to the entire market.
A characteristic line is a part of the set of tools known as Modern Portfolio Theory (MPT) that are used to assess market performance and security performance. Investors can also plot and regress other characteristics of a security or the overall market to help measure risk and make decisions.