The security market line (SML) is a visual representation of the capital asset pricing model (CAPM). SML is a theoretical representation of the expected returns of assets based on systematic or non-diversifiable risk.
The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of its systematic risk, which cannot be eliminated by diversification.
A beta value of one is considered the overall market average.
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 than the market average.
Key Features:
- 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).
- The SML can help to determine whether an investment product would offer a favorable expected return compared to its level of risk.
- The formula for plotting the SML is required return = risk-free rate of return + beta (market return – the risk-free rate of return).
Components of the SML
The security market line is made up of the risk-free rate, the beta of the asset related to the market, and the expected market risk premium. The components will yield the expected return of an asset. Additionally, the SML formula can be used to calculate the asset’s risk premium. Below is the formula to calculate the security market line:
Security Market Line = Risk-Free Rate + [Beta * (Expected Market Return – Risk-Free Rate)]
Where:
- Risk-Free Rate – Current risk-free rate
- Beta – Beta of the security to the market
- Expected Market Return – Expected return of all risky assets
Plotting the function for all positive betas, with the constraint of a positive market risk premium (Expected Market Return – Risk-Free Rate), will give the typical security market line. To get the expected risk premium of a security, subtract the first risk-free rate from both sides of the equation. It will produce:
Expected Security Risk Premium = Beta * (Expected Market Return – Risk-Free Rate)
Uses of Security Market Line
The security market line is commonly used by money managers and investors to evaluate an investment product that they’re thinking of including in a portfolio.
The SML is useful in determining whether the security offers a favorable expected return compared to its level of risk.
When a security is plotted on the SML chart, if it appears above the SML, it is considered undervalued because the position on the chart indicates that the security offers a greater return against its inherent risk.
Conversely, if the security plots below the SML, it is considered overvalued in price because the expected return does not overcome the inherent risk.
The SML is frequently used in comparing two similar securities that offer approximately the same return, in order to determine which of them involves the least amount of inherent market risk relative to the expected return.
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.
Security Market Line Assumptions
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.
The larger the level of systematic risk, the larger the expected return for the security is – more risk equals more reward.
It is a linear relationship and explains why the security market line is a straight line. However, very broad assumptions need to be made for a one-factor model to be upheld. Below are some SML assumptions:
- All market participants are price takers and cannot affect the price of a security.
- The investment horizon for all investors is the same.
- There are no short sales.
- There are no taxes or transaction costs.
- There is only one risk-free asset.
- There are multiple risky assets.
- All market participants are rational.
