Which approach does the SML method use to incorporate risk?

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The correct approach that the Security Market Line (SML) method uses to incorporate risk is through the analysis of historical data. The SML is a key aspect of the Capital Asset Pricing Model (CAPM), which maps the relationship between expected return and systematic risk, measured by beta.

In constructing the SML, historical returns of the market and individual assets are analyzed to establish a relationship between their returns and risks over time. This relationship is crucial for determining the expected return for a given level of risk, guiding investors in making informed decisions about asset allocation and investment strategies. By looking at past performance, investors can assess how different levels of risk correspond to expected returns, thus allowing them to make more educated predictions about future performance based on that historical context.

Other methods such as direct observation of stock prices, estimation of future cash flows, or fixed return assumptions do not provide a robust framework for incorporating risk in the systematic manner that historical data analysis does in the context of the SML. These alternatives may overlook the risk-return relationship illuminated by historical performance, which is central to the rationale behind the SML’s application in finance.

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