Security market line (SML)

Description

Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk.

The Y-intercept of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time

RM is a market rate of return.

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 amount of risk, they yield a lower return.

There is a question about what the SML looks like when beta is negative. A rational investor will accept these assets even though they yield sub-risk-free returns, because they will provide “recession insurance” as part of a well-diversified portfolio. Therefore, the SML continues in a straight line whether beta is positive or negative. A different way of thinking about this is that the absolute value of beta represents the amount of risk associated with the asset, while the sign explains when the risk occurs

Related formulas

Variables

ERiexpected return on security (dimensionless)
Rfrisk-free rate (dimensionless)
βinondiversifiable or systematic risk (beta of the investment) (dimensionless)
ERMexpected return on market portfolio M (dimensionless)