Security Market Line - SML
What Does Security Market Line - SML Mean?
A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable
securities.
Also refered to as the "characteristic line".
Investopedia explains Security Market Line - SML
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-
axis represents the expected return. The market risk premium is determined from the slope of the SML.
The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return
for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is
undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because
the investor would be accepting less return for the amount of risk assumed.
Security market line (SML) is the graphical representation of the Capital asset pricing model. It displays the expected rate of return of an
individual security as a function of systematic, non-diversifiable risk (its beta).[1]
]Formula
The Y-intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the market risk premium and
reflects the risk return trade off at a given time:
When used in portfolio management, the SML represents the investment's opportunity cost (investing in a combination of the market
portfolio and the risk-free asset). All the correctly priced securities are plotted on the SML. The assets above the line are undervalued
because for a given amount of risk (beta), they yield a higher return. The assets below the line are overvalued because for a given
amount of risk, they yield a lower return.[2]
There is a question what the SML is when beta is negative. A rational investor should reject all the assets yielding sub-risk-free
returns, so beta-negative returns have to be higher than the risk-free rate. Therefore, the SML should be V-shaped.
he formula for CAPM is Ks = Krf + B ( Km - Krf).
Let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of
return of 12.5% next year. You see that XYZ company (Read our disclaimer) has a beta of 1.7
I f you make a graph of this situation, it would look like this:
On the horizontal axis are the betas of all companies in the market
On the vertical axis are the required rates of return, as a percentage
The red line is the Security Market Line.
How did we get it? We plugged in a few sample betas into the equation
Ks = Krf + B ( Km - Krf).
Security Beta (measures risk) Rate of Return
'Risk Free' 0.0 5.00%
Overall Stock Market 1.0 12.50%
XYZ Company 1.7 17.75%
CFA Level 1 - The Security Market Line (SML)
The Security Market Line
The security market line (SML) is the line that reflects an investment’s risk versus its return, or the return on a given investment in relation to risk. The
measure of risk used for the security market line is beta.
The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the
return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An
investor with a higher risk profile would thus choose an investment higher along the security market line.
Figure 17.1: Security Market Line
Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the
investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If
the risk premium required by investors was to change, the slope of the SML would change as well.
When a shift in the SML occurs, a change that affects all investments’ risk versus return profile has occurred. A shift of the SML can occur with
changes in the following:
1. Expected real growth in the economy.
2. Capital market conditions.
3. Expected inflation rate.
security market line
Main article: Security market line
The SML graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The
market risk premium is determined from the slope of the SML.
The relationship between β and required return is plotted on the security market
line (SML) which shows expected return as a function of β. The intercept is the nominal The Security Market Line
risk-free rate available for the market, while the slope is E(Rm)− Rf. The security market
line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The
equation of the SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual
securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued
because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting a lower return for the amount of risk assumed.
