Characteristic Line
What Is a Characteristic Line?
A characteristic line is a straight line framed utilizing regression analysis that sums up a particular security's systematic risk and rate of return. The characteristic line is otherwise called the security characteristic line (SCL).
The characteristic line is made by plotting a security's return at different points in time. The y-hub on the chart measures the excess return of the security. Excess return is measured against the risk-free rate of return. The x-hub on the chart measures the market's return in excess of the risk free rate.
The security's plots uncover the way that the security performed relative to the market overall. The regression line shaped from the plots will show the security's excess return over the measured period of time as well as the amount of systematic risk the security demonstrates. The y-catch is the security's alpha, which addresses its rate of return in excess of the risk-free rate, which can't be represented by that market's specific risks. As per Modern Portfolio Theory (MPT), the alpha represents the asset's rate of return far in excess of its risk-free return, adjusted for the asset's relative riskiness. The incline of the characteristic line is the security's systematic risk, or beta, which measures the connected variability of the specific asset's price when compared to that of the market as a whole.
What the Characteristic Line Shows
The characteristic line presents a visual representation of how a specific security or other asset performs when compared to the performance of the market as a whole. The return, and corresponded risk, of a specific asset, relative to the market as a general rule, are addressed by both the incline of the characteristic line and its standard deviation.
How a Characteristic Line Works
The characteristic line is part of a more extensive set-up of security and market performance assessment instruments known as Modern Portfolio Theory (MPT). Notwithstanding the characteristic line regression, different characteristics of a security or the overall market can be plotted and relapsed to assist an investor with estimating risk and decide.
Other MPT Tools
Other logical apparatuses in the Modern Portfolio Theory family are the security market line (SML), the capital market line (CML), the capital allocation line (CAL), and the capital asset pricing model (CAPM). Calculating the characteristic line is a means of graphically depicting the CAPM. These systems utilize different developments of risk, excess return, overall market performance, security beta, and individual security performance to evaluate the risk/return tradeoff and illuminate investment choices.
As per MPT and the CAPM, rates of return ought to increase relative to the riskiness of an asset. At the point when risk goes up, returns go up also. Rates of return are hence said to rely upon endlessly risk can be measured in terms of the variability of returns. Returns higher than the risk-free interest rate plus an extra level of compensation for accepting higher risk are supposed to be abnormal. Nonetheless, assets frequently display abnormal returns. Those showing abnormally high returns are supposed to be undervalued, while those with abnormally low returns are supposed to be overvalued.
Highlights
- A characteristic line demonstrates a security's systematic risk and rate of return.
- This line shows the security's performance versus the market's performance.
- The characteristic line is additionally alluded to as the security characteristic line.
