Security market line
Security market line or SML is a graphical representation of the returns expected to be provided by a security given the amount of systematic risk taken in by it.
The graph’s X axis has the systematic risk, which is measured by beta, while the expected returns is on the Y axis. SML starts on Y axis at the risk-free returns value (in the market).
X axis is the systematic risk which is beta, Y axis is the expected return (ER), Rf is the risk
M-free returns rate, such as the returns rate of government bonds, treasury bills.
The security market line is a graphical representation of the Capital asset pricing model (CAPM). The securities market line is used by investors to determine whether to include a security in their portfolio or not.
If the security is plotted above the SML, it is said to be undervalued, if plotted below the SML, it is said to be overvalued. Either way, Alpha can be generated by a suitable trade.
In the graph, as the risk assumed by the security increases, the ER also increases.