Draw the SML and plot asset C such that it has less risk than the market but plots above the SML, and asset D such that it has more risk than the market and plots below the SML. (Be sure to indicate where the market portfolio is on your graph.) Explain how assets like C or D can plot as they do and explain why such pricing cannot persist in a market that is in equilibrium.

The student should draw a picture similar to Figure 13.9, adding a point where the market portfolio exists. In this case, asset C is underpriced and asset D is overpriced. This condition cannot persist in equilibrium because investors will buy C with its high expected return and sell D with its low expected return. The resultant buy and sell activity will force the prices back to a level that eventually causes both C and D to plot on the SML.