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Security Market Line
Security Market Line
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
]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
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
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
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
How did we get it? We plugged in a few sample betas into the equation
Ks = Krf + B ( Km - Krf).
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.
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
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
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.