Amy Rose F.

Abalunan BA206
MBA Prof. Vincent Ray Boron

Risk and Return and the security market line

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM), which shows different levels of
systematic, or market, risk of various marketable securities plotted against the expected return
of the entire market at a given point in time. Also known as the "characteristic line," the SML is
a visual of the capital asset pricing model (CAPM), where the x-axis of the chart represents risk
in terms of beta, and the y-axis of the chart represents expected return. The market risk
premium of a given security is determined by where it is plotted on the chart in relation to the
SML.
The security market line is useful to determine if an asset being considered for a portfolio offers
a reasonable expected return for risk.
systematic risk
The risk associated with an asset that is correlated with the risk of asset markets generally,
often measured as its beta.
non-systematic risk
Risk that is unique to a specific company; can be reduced through diversification.
capital asset pricing model
Used to determine the required rate of return of an asset considering an asset's sensitivity to
non-diversifiable risk (also known as systematic risk or market risk).
security market line
A line representing the relationship between expected return and systematic risk; thus, a
graphical representation of the capital asset pricing model.

Investment assets are typically characterized as having two performance risks: systematic (or

market risk) and non-systematic risk. Systematic risk arises from market structure or dynamics,

which produce shocks or uncertainty faced by all agents in the market. Non-systematic risk is

unique to a specific company and can be reduced through diversification.

Capital Asset Pricing Model (CAPM)

In finance, the capital asset pricing model (CAPM) is used to determine the required rate of

return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic

risk. Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if

the asset's price sensitivity is greater than the market; equal to one when the asset's sensitivity

is equal to the market; and less than one if the asset exhibits less pricing volatility than the

market.

The CAPM is a model for pricing an individual security or portfolio. The expected return of an

asset is equal to the risk free rate plus the excess return of the market above the risk-free rate,

adjusted for the asset's overall sensitivity to market fluctuations or its beta. Mathematically, the

capital asset pricing model can be written as: E(Ri) = Rf + β(E(Rm) - Rf), where R is the return,

E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.

Security Market Line (SML)

For individual securities, the security market line (SML) and its relation to expected return and

systematic risk (beta) depicts an individual security in relation to their security risk class . The

SML essentially graphs the results from the capital asset pricing model 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 SML, which shows expected return as a function of β. The intercept is

the nominal risk-free rate available for the market, while the slope is the market premium,

E(Rm)− Rf.
Security market line

The security market line depicts the the return on a security relative to its own risk.

The SML 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 expected return versus risk is plotted above the SML, it is undervalued since the

investor can expect a greater return for the inherent risk. A security plotted below the SML is

overvalued since the investor would be accepting a smaller return for the amount of risk

assumed.
https://www.investopedia.com/terms/s/sml.asp

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