Understanding the Security Market Line

Thus, with the security market line, if an asset is providing too large of a return, it means that it is underpriced. This abnormal extra return above the market's return at a given level of risk is what is called the alpha. In theory, the market has correctly priced the security if it can be plotted directly on the SML, i.e. the market is in a state of “perfect equilibrium”.

However, the investor, who maintains a diversified portfolio of different stocks, has already eliminated the company specific risk portion of the total risk. In this case he does not base the market price of a new buying stock on the total risk but only on the market risk portion. The risk premium of a stock is based on only the market risk elements of total risk. So, the stock’s market price depends on the required return in an efficient market, which in turn depends on the risk premium. This risk premium finally depends on the market portion of the risk.

System Views of Management

And, if you have got any questions or feedback, you can use our contact form to reach us. The primary objective behind drawing these lines is to get an idea regarding whether any particular investment will be offering a favourable return with respect to its corresponding levels of risk. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.

SML serves as a visual representation of the capital asset pricing model (CAPM) that displays the systematic or market risks of securities. While the x-axis represents the beta or the risk of the assets, the y-axis represents the expected return of the assets. The security market line (SML) is otherwise called the characteristic line. The beta of a security is an important metric when using SML or CAPM, this metric indicates the non-diversifiable risk or systematic risk of an asset. When calculating the market average, the beta is also a vital metric.

The beta of a security is a measure of its systematic risk, which cannot be eliminated by diversification. A beta value that's greater than one represents a risk level greater than the market average, and a beta value of less than one represents a risk level that is less security market line formula than the market average. The CML is the Capital Market Line which is a visual representation of the relationship between expected return and risk. This is an extension of the CML and it shows the trade-off between risk and return for a well-diversified portfolio.

What Is the Capital Market Line (CML)?

Therefore, risky assets are expected to lie off the security market line only temporarily as such mispricings are quickly exploited by arbitrageurs whose trades help restore pricing efficiency. For stock A, we expect investors to form a portfolio that has the same beta but that lies on the SML. They would then go long in stock A and short in the portfolio to earn arbitrage profits. The purchases of stock A would increase the price of this stock until it falls back onto the security market line.

The SML is useful in determining whether the security offers a favorable expected return compared to its level of risk. From the above answer it is obvious that the investor requires the return of 45% on the stock X. On the other hand the market required rate of return is 15% but the investors ROR is much higher than it. Basically, it means that the stock X is 3 times more risky than the market. So, the investor wishes for a higher ROR than the expected ROR of the market. Although, which is unfavorable for the investor to accomplish his goals.

What is a Security Market Line?

Since the security market line is a graphical representation of the capital asset pricing model (CAPM), the assumptions for CAPM also hold for SML. Most commonly, CAPM is a one-factor model that is only based on the level of systematic risk a security is exposed to. Fundamentally, a higher degree of systematic risk (i.e. undiversifiable, market risk) in a security should result in investors requiring a higher rate of return as compensation for the greater level of risk. The security market line differs from the capital market line (CML) which plots the required return on a portfolio of risk-free asset and the market portfolio with reference to the portfolio’s standard deviation.

If you are looking to invest in any security, you should compare its risks and your own risk appetite before taking any decision. Hence, we can safely conclude that any security whose position is above the SML will offer higher returns than expected at the same level of systematic risk. In contrast, all securities positioned under this particular line will give lower returns than expected returns derived from the CAPM. In this chart, the X-axis represents the level of systematic risk. Furthermore, the Y-axis represents the expected return at a particular level of risk. Since the beta of the market is constant at 1.0, the slope can be re-written as the market return net of the risk free rate, i.e. the equity risk premium (ERP) formula from earlier.

What Is the Equation of the Security Market Line?

One of the significant differences between these two concepts is that SML depicts the risk and expected returns of a single security. On the other hand, the capital market line depicts the risk and return trade-off of the entire investment portfolio. Thus, the equity risk premium (ERP) represents the slope of the security market line (SML) and the reward earned by the investor for bearing the stated systematic risk. The SML can also be used to compare securities of equal risk to see which one offers the highest expected return against that level of risk.

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Table of Contents

It is important to remember that the CML is a model and that real-world conditions may not always reflect the model. However, the CML provides a good starting point for investment analysis. The capital market line (CML) is a straight line that shows the relationship between risk and return of different portfolios. The CML is according to the assumption that all investors are rational and seek to maximize their returns. In the formula given above, the expected return that the investors desire by investing in that stock (rA). You can figure the slope of the Security Market Line with a simple formula in Excel.

Security Market Line (SML) is a two-dimensional graphical representation of the expected return and beta of security. If an expected return is found above the Security Market Line, then it is undervalued, and below it, then security is overvalued. Currently, the yield of treasury security is 2% and market risk premium is 4%. An example of common proxies is the Dow Jones Industrial Average (DJIA), S&P 500 Index, and the NASDAQ 100.

The CML helps find the best portfolio, which is the portfolio that provides the highest expected return for a given level of risk. In the light of the given data, calculate the required rate of return of a stock X. For stock B, investors would form a correctly-priced portfolio that has the same beta as stock B. This time, they would go long in the portfolio and short-sell stock B to exploit the mispricing. This would put downward pressure on the price of stock B until it goes down to the level predicted by the CAPM. Draw the Security Market Line (SML), write the equation of the SML line, plot the required return and the expected return, and indicate to which direction the expected return should move.

The market risk premium of a given security is determined by where it is plotted on the chart relative to the SML. Furthermore, while the market portfolio lies on the CML, individual securities (e.g., stocks) lie below that. In contrast, both the market portfolio and the individual securities are expected to lie on the SML. More broadly, the SML plots the expected market returns for a marketable security at a given level of market risk for the marketable security. The level of risk is determined by the beta of a security against the market.

• 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).
• Draw the Security Market Line (SML), write the equation of the SML line, plot the required return and the expected return, and indicate to which direction the expected return should move.
• There are also certain market forces that push any extraordinary located stock towards the SML.
• This results in the optimal risky portfolio such that the line that connects the risk-free asset and the optimal risky portfolio is tangent to the efficient frontier.

The security market line can also be used to graphically understand the pricing of an asset. However, the security market line is not always applicable in practice, as there are very broad assumptions involved that do not always apply. In effect, the SML displays the expected return on an individual security at different levels of systematic risk. There are three components to the CAPM formula, which are the risk-free rate (rf), the beta (β) and the equity risk premium (ERP). The required rate of return, or “discount rate“, is one of the primary determinants that guide the decision-making process of an investor on whether to invest in the security. CML is an effective tool for evaluating investments and determining the required return on an investment.