What is a Characteristic Line?
In financial markets theory, a characteristic line graphically represents the relationship between the rates of return of a financial security or other asset, such as a share of stock in a company, and the rates of return of all the assets available on a market. Also known as a security market line, the characteristic line takes the form of a straight line with the y-axis intercept representing the return of a security in excess of the risk-free return and the x-axis representing that for a portfolio made up of all assets in the market. The values that make up the characteristic line are obtained by performing a statistical regression analysis. The return and correlated risk of an equity security or other asset relative to all the assets in the market taken together are represented in the slope and standard deviation of the characteristic line, which define the asset’s beta.
The slope of the characteristic line is the stock’s beta (β), a measure of the correlated variability of a security or other asset’s price as compared to that of the market as a whole. The line’s vertical, y-axis intercept represents the asset’s alpha (α), the rate of return in excess of the risk-free rate that cannot be accounted for by risks specific to the particular market. In modern portfolio theory, alpha represents the rate of return over and above the risk-free return adjusted for the relative riskiness of the asset.
Depicting the relative risk-adjusted rates of return for shares of stock or other assets, the characteristic line is a graphical representation of the Capital Asset Pricing Model (CAPM) and is central to Modern Portfolio Theory (MPT). As per the CAPM and MPT, the rates of return of an equity security or other asset should increase along with increases in risk. The rates of return are said to depending on risk as measured by the variability in returns. Returns that exceed the risk-free rate of interest plus additional compensation for assuming a higher degree of risk are said to be abnormal when viewed from the perspective of CAPM and MPT.
Securities 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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