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The characteristic line represents the relationship between rates of return on a financial security and all assets available in a market. It is a graphical representation of the Capital Asset Pricing Model and is fundamental to modern portfolio theory. Stocks above the line offer high returns relative to their risk and are undervalued, while those below are overvalued.
In financial markets theory, a characteristic line graphically represents the relationship between the rates of return on a financial security or other asset, such as a share of a company’s stock, and the rates of return on all assets available in a market. market. Also known as the stock market line, the characteristic line takes the form of a straight line with the intersection of the y-axis representing the return of a security that exceeds the risk-free return and the x-axis representing that of a composite portfolio. of all assets in the market. The values that make up the characteristic line are obtained by performing a statistical regression analysis. The correlated return and risk of a security or other asset relative to all assets in the market taken together are represented by the slope and standard deviation of the characteristic line, which defines the asset’s beta.
The slope of the characteristic line is the stock’s beta (ß), a measure of the correlated variability of a value of a security or other asset compared to that of the market as a whole. The vertical intersection of the y-axis of the line represents the asset’s alpha (a), the rate of return above the risk-free rate that cannot be explained by risks specific to the particular market. In modern portfolio theory, alpha represents the rate of return above the risk-free return adjusted for the relative risk of the asset.
The characteristic line is a graphical representation of the Capital Asset Pricing Model (CAPM) and represents the relative risk-adjusted rate of return for stocks or other assets, and is fundamental to modern portfolio theory (MPT). Under the CAPM and MPT, the rates of return on a security or other asset should increase along with increases in risk. Rates of return are said to depend on risk as measured by variability in returns. Returns in excess of the risk-free interest rate plus additional compensation for assuming a higher degree of risk are said to be abnormal when viewed from the CAPM and MPT perspective.
Stocks and other assets routinely exhibit abnormal positive and negative returns in real world markets. Stocks or other assets with returns above the characteristic line offer abnormally high returns relative to their risk and are considered undervalued. Conversely, those that fall below the characteristic line offer abnormally low returns relative to their risk and are considered overvalued.
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