The security market line (SML) is a graphical form of the capital asset pricing model (CAPM). It is a line on a graph that represents the relationship between the expected return on an investment and various levels of systematic risk.
Investors use the security market line to evaluate whether or not an investment is worth the inherent risk. It is mostly instrumental for investors who seek higher returns for taking higher risks on an investment.
Why Is SML Important?
SML helps investors in the proper evaluation and assessment of assets. Every investment has some risks inherent in them and these risks combine to determine the expected return.
With the SML, investors can get a clearer view of how their investment will perform at different levels of risk. As such, it helps investors in the management of their investing portfolio.
By determining the pricing of risky assets, investors can make better-informed decisions on their investments to add to their portfolio. The SML represents the CAPM and as such, puts systematic risks into consideration.
Systematic risks are market risks that investors cannot avert or manage by diversifying their investment. They are inherent in every investment and are difficult to avoid completely.
Security Market Line & Capital Asset Pricing Model
The CAPM chart helps investors to estimate whether an asset is overpriced or underpriced. This can be determined by comparing an asset’s expected return relative to its systematic risks, to the market.
Hence, the SML graph plots the systematic risks of an investment – usually measured by beta – against its expected return. If an asset plots above the SML, the asset is said to be underpriced/undervalued.
This means that the security can expect to yield a return higher than its systematic risks. Contrarily, plotting an asset below the SML shows that the asset is overvalued.
This means that the expected return on the investment is lower than the expected return.
What Is the Capital Asset Pricing Model (CAPM)?
The capital asset pricing model (CAPM) is a financial model that calculates the expected return on investments, based on the inherent risks. The CAPM assists investors in determining the pricing of an asset, taking into account the systematic risks.
When Do We Use SML?
The SML is mostly used by investors during the evaluation of securities. It is used to assess prospective investment products to decide whether to include them in an investment portfolio.
Investors use the SML to compare two securities that are closely matched in terms of returns to determine which one involves the least risks. Conversely, the SML can be used to compare securities at the same risk level to determine which one yields more returns.
The SML Formula
The formula for calculating SML is:
SML = Rf + B (MTr – Rf)
- Rf – Risk-free rate of return
- B – Beta coefficient
- MTr – Market rate of return
Let’s consider each of the parameters of the SML equation.
Risk-Free Rate of Return
The risk-free rate of return calculates the return rate an investor will get on an investment over a period of time at a near-zero risk. This, in other words, defines the lowest possible return an investor stands to get on an investment.
A high risk-free rate means that an investor is most likely going to get a high return even on a low-risk level. Contrarily, a low risk-free rate implies that the rate of return of an investment at a low-risk level is expected to be low.
The risk-free rate of return is only a theory and does not exist in practice. This is because every investment has a certain amount of risk inherent in it. So, technically there’s no fully risk-free investment.
A beta above 1 implies that a security is more volatile than the market while a beta of 1 is the market average. An asset with a beta of less than 1 is less volatile than the market.
This is the expected return rate for the investment instrument in the market. In the calculation of the SML, the expected market return rate is compared with the risk-free return rate.
Example of SML
Suppose the risk-free rate on an investment is 5% and that the expected market return is 20%. Consider two different securities, P and Q. Assume that P has a beta of 0.5 while Q has a beta of 1.9.
Let us calculate the SML for both investments. Following the SML formula:
Expected return for A: 5 + 0.5 (20 – 5)).
Estimated return = 12%
Expected return for B: 5 + 1.9(20 – 5)
Expected return = 33.5%.
Why Is SML a Straight Line?
The relationship between the systematic risks and the expected return is a linear one. This means that the higher the systematic risks, the higher the expected return.
This is why the security market line is a straight line.
What Is the Slope?
The slope of a security market line is the market risk premium. The market risk premium represents the extra return an investor gets for taking higher risks.
In other words, it is the excess of the expected return on an investment above the risk-free rate.
Can It Ever Be Downward Sloping?
Conventionally, the security market line is always an upward sloping line except on some special conditions. A downward-sloping SML may be perceived when assets have a low market supply and at the same time, have a high market beta.
In this case, the relationship between the average excess return and the beta is no longer a straight line.
Plotting on the SML: What Is Alpha?
In the course of an investment, the return on the investment may increase or decrease in comparison with the expected return. This can be influenced by factors such as the demand and supply for an asset.
The difference between the actual return on investment and the expected return is known as the alpha.
When the alpha is positive, the return on investment increases, and as such, investors earn more. Hence, a high alpha indicates that a security is underpriced/undervalued as the return is higher than the measure of risk.
Unlike high alphas, a low alpha indicates that a security is overpriced. When the price of a stock rises above the expected price due to, say, an increase in demand, the expected return is reduced and the stock is overvalued at that point.
What Causes SML To Shift?
The SML responds to changes in the amount of risk associated with securities. As the systematic risks of an investment increases, there’s an upward movement in the SML.
For instance, an increase in the interest rates in the market increases the risk level of assets in that market. As such, investors will demand a higher score return as compensation for taking higher risks.
This means that the stock becomes overpriced and as such, the stock may move down the SML.
SML and CML
Both the security market line and the capital market line (CML) are tools for risk/return relationship analysis in the world of investment. Investors use both tools to evaluate the return on an investment or portfolio given some risks.
They assist investors to make better decisions for profitable investments.
What Is the Capital Market Line?
The capital market line graphically represents all the portfolios that combine risk and return optimally. It shows the relationship between the efficient portfolios’ expected return and the total risks associated with them.
The security market line is a derivative of the capital market line. The CML represents the return rates for a specific portfolio.
On the other hand, the SML depicts the return investors expect from individual assets at a given time.
Key Differences Between SML and CML
The CML illustrates the risk-return relationship for efficient portfolios while the SML illustrates the risk-return for individual investments.
The system of risk measurement for the CML is the standard deviation or total risk factor. Conversely, the SML measures risk through the beta of an investment. The beta indicates how a security responds to the movements of the market. It measures how the risk of a security contributes to the entire portfolio.
The capital market line represents only efficient portfolios. On the other hand, the SML represents all portfolios, whether efficient or not.
The CML determines the market portfolio and risk-free assets while the SML determines all security factors. The y-axis of the CML plots the expected return of the portfolio while the y-axis of the SML plots the expected return on each security.
Proper evaluation of the risk-return relationship of investments and investment portfolios is key to maintaining a profitable investment. The SML gives you a graphical illustration of this relationship so you can invest in securities that maximize returns.
For accurate assessment of investment risks and the expected returns, you may need to consult a financial advisor.