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 any given time.Also known as the "characteristic line," the SML is a visualization of the 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 relative to the SML.
Definition: The Security Market Line (SML) is a line drawn on a chart that represents the Capital Asset Pricing Model (CAPM). It shows the different levels of systematic risk or market risk for various tradable securities, corresponding to the expected return of the entire market at any given time. Also known as the 'characteristic line,' the SML is a visualization of the CAPM, with the x-axis representing risk (measured by beta) and the y-axis representing expected return. The market risk premium for a given security is determined by its position relative to the SML on the chart.
Origin: The concept of the Security Market Line originates from the Capital Asset Pricing Model (CAPM), which was introduced by William Sharpe in the 1960s. The CAPM aims to estimate the expected return of a security by considering systematic risk, thereby helping investors make more informed investment decisions.
Categories and Characteristics: The SML has several key characteristics:
- Systematic Risk: The SML only considers systematic risk (market risk), not unsystematic risk (individual risk).
- Linear Relationship: The SML demonstrates a linear relationship between risk and expected return; higher risk leads to higher expected return.
- Market Equilibrium: In a state of market equilibrium, the expected returns of all securities should lie on the SML.
Specific Cases:
- Case 1: Suppose an investor is evaluating two stocks, A and B. Stock A has a beta of 1.2, and Stock B has a beta of 0.8. Assuming a risk-free rate of 2% and a market expected return of 8%, the expected return for Stock A according to the SML formula would be 2% + 1.2 * (8% - 2%) = 9.2%, and for Stock B, it would be 2% + 0.8 * (8% - 2%) = 6.8%.
- Case 2: A fund manager finds that a stock C has an expected return of 10% and a beta of 1.5. According to the SML formula, assuming a risk-free rate of 2% and a market expected return of 8%, the expected return for Stock C should be 2% + 1.5 * (8% - 2%) = 11%. Since the actual expected return is lower than the return on the SML, the fund manager might consider the stock to be overvalued.
Common Questions:
- Q: Why does the SML only consider systematic risk?
A: Because systematic risk cannot be eliminated through diversification, whereas unsystematic risk can be reduced by diversifying the investment portfolio. - Q: What does it mean if a security's expected return is below the SML?
A: This usually means that the security is overvalued, and investors might choose to sell it.
