Security Market Line

Security market line meaning

  • SML indicates the returns expected to be provided by security given the amount of systematic risk taken in by it
  • It is a graphical representation of an investment opportunity cost.
  • The SML formula is: Expected Return = Risk-free rate of return + β (Market Return – Risk-free rate of return)

What is a Security market line?

Security market line or SML is a graphical representation of the returns expected to be provided by security given the amount of systematic risk taken in by it. The securities market line is used by investors to determine whether to include security in their portfolio or not.

The graph’s X-axis has systematic risk, which is measured by beta, while the expected returns are on the Y axis. SML starts on Y axis at the risk-free returns value (in the market).

Security Market Line Formula:

The security market line is a graphical representation of the Capital asset pricing model (CAPM).

Expected Return = Risk free rate of return + β (Market Return – Risk free rate of return)

The X-axis is the systematic risk, which is beta, Y-axis is the expected return (ER), Rf is the risk-free returns rate, such as the returns rate of government bonds, treasury bills.

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.  

Security Market Line Slope

The slope of the security market line represents the market risk premium, i.e. the excess return over the market return. The market risk premium compensates for the additional systematic risk associated with the security. Therefore, the higher the risk, the higher the market risk premium for the security, and the higher the expected overall return for the security.

Characteristics of a Security Market Line

Security Market Line has the following characteristics:

·   It is a very good representation of an investment opportunity cost.

·   A security or a portfolio with a value of beta equal to zero has its expected return the same as the risk-free rate of return.

·   Market risk premium determines the slope of the security market line. The slope gets steeper with the increasing value of market risk premium.

·   All the appropriately priced assets are represented on the security market line.

·   Assets lying above the security market line are undervalued because they give greater expected returns at a given value of risk.

·   Assets lying below the security market line are overvalued because they give lower expected returns at a given value of risk.

Security Market Line Example

Let us take an example to understand the security market line better. Let’s say that the risk-free rate is 5% and the value of the expected market rate of return is 14%. There are two securities having two different values of beta. One security has a beta value of 0.5 and another has a beta equal to 1.5.

The expected rate of return of the security can be calculated as:

Expected Return of security with beta equal to 0.5 = Risk-free rate of return + β (Market Return – Risk-free rate of return)

                                                                               = 5+0.5(14-5) = 9.5%

Expected Return of security with beta equal to 1.5 = Risk-free rate of return + β (Market Return – Risk-free rate of return)

                                                                          = 5+1.5 (14-5) = 18.5%

How do you read a security market line?

If the security is plotted above the SML, it is said to be undervalued. The reason for the interpretation is that if the security falls above the SML, the security provides a higher return for a given level of risk implying that opportunity is not yet exploited by the market.

Similarly, if the security is plotted below the SML, it is said to be overvalued giving lower returns than the market for a given level of risk. Such security is overbought.

Either way, Alpha can be generated by a suitable trade. In the graph, as the risk assumed by the security increases, the expected return also increases.

Limitations of Security Market Line

Limitations of the security market line are:

·   The market return used in the formula is measured from past results which may not hold true in the future.

·   The risk-free rate used in plotting the security market line may change over time and may lead to volatility.

·   Beta is a crucial component in plotting the security market line but often it is very difficult the accurate value of beta which questions the reliability of results obtained from the security market line.

What is the difference between SML and CML?

SML represents Security Market Line and CML represents Capital Market Line.

Point of Difference Security Market Line Capital Market Line
Meaning SML is used to show the risk and return for individual securities CML indicates the risk and returns for a portfolio of securities
Risk factor metric Beta of a security Standard Deviation of the portfolio
Risk considered Systematic Risk Total Risk (systematic plus unsystematic)
Representation Depicts all market portfolios, efficient or non-efficient Only depicts efficient portfolios