In the SML framework, which parameter must be estimated from historical data?

In the Security Market Line (SML) framework, all the parameters—risk-free rate, expected return on the market, and beta of the stock—are integral to calculating the expected return of an asset based on its systematic risk. Each of these elements is typically derived from historical data, making the choice of all of the above the correct answer.

The risk-free rate is often approximated using the yield on government bonds, typically of short duration, as these are considered free of default risk. Historical yield data is used to estimate what this rate has been over a specific timeframe.

The expected return on the market is generally estimated using historical returns on a market index, such as the S&P 500. This estimation includes looking at past performance to evaluate what investors might expect in the future.

Beta, which measures the sensitivity of a stock’s returns in relation to the returns of the market as a whole, is also derived from historical data. It involves statistical calculations using past price movements of both the stock and the market index to determine how much the stock fluctuates relative to market changes.

Overall, all these parameters require historical data for accurate estimation, ensuring that investors can make informed decisions based on the SML framework.