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How to use the Characteristic Line to measure the risk and return of a security?
A Characteristic Line (CL) measures the risk and the related return of a security. The returns of a security at different times are plotted on a line that takes a form of a straight line which is the characteristics line (CL).
The CL represents the performance of the security in comparison to the market risks. The stock returns are placed on the Y-axis of a graph and the stock market returns are placed on the X-axis. The beta coefficient of the graph provides the slope of the characteristic line. The slope and standard deviation of the characteristic line, define the asset’s beta.
Note − The CL is a straight line drawn on a graph that represents the relation over time between returns on a stock and a return on the market. The line represents a stock's vertical intercept (alpha) and the line's slope (beta). The line highlights the difference between systematic and unsystematic risks.
The slope of the CL is the stock’s beta (β), which is a ratio of the correlation of variability of a security’s price as compared to that of the market as a whole.
The CL’s vertical line, the Y-axis intercept represents the asset’s alpha (α), which is the rate of return apart from the risk-free rate. This rate cannot be accounted for by the risks specific to the particular market. In modern portfolio theory, alpha represents the rate of return over the risk-free return adjusted for the relative risk of the asset.
Depicting the comparable risk-adjusted rates of return for the shares of stock or other assets, the CL is a graphical representation of the Capital Asset Pricing Model (CAPM). It is the base of Modern Portfolio Theory (MPT). As per the CAPM and MPT, the rewards or returns from an equity investment should increase along with increased risk.
Note − The CL is a line drawn using regression analysis that shows particular security or portfolio's systematic risk and rate of return. The rate of return of a security is based on the standard deviation of the returns and the slope of the characteristic line also known as the asset's beta.
Undervalued and Overvalued Securities
The rates of return depend on risk measured by the variation in returns. Returns that go above the risk-free rate of interest plus additional compensation for anticipating a higher degree of risk are said to be abnormal when seen from the perspective of CAPM and MPT.
Securities and other assets usually routinely represent abnormal positive and negative returns in real-world markets. Stocks or other assets that provide returns above the CL offer unusually high returns relative to the risk and are called undervalued. Conversely, those that fall under the characteristic line offer unusually low returns relative to the risk are called overvalued.
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