What is the 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.

The SML, also called the “characteristic line,” is a chart that visualizes the CAPM. The y-axis of the chart shows anticipated return, while the x-axis shows risk (measured in terms of beta). The location of a security plot on the chart about the SML indicates its market risk premium.

Understanding the Security Market Line

Based on the idea that investors must be compensated for both the time value of money (TVM) and the corresponding level of risk associated with any investment, known as the risk premium, the security market line is an investment evaluation tool that is derived from the Capital Asset Pricing Model (CAPM). This model describes the risk-return relationship for securities.

The SML and the CAPM both rely heavily on the idea of beta. A security’s beta measures its systematic risk, which diversification cannot remove. The total market average is defined as having a beta value of one. A beta value of less than one indicates a risk level below the market average, whereas a beta value of more than one indicates a risk level above the average.

To plot the SML, use the following formula:

The risk-free rate of return plus beta (the market return minus the risk-free rate of return) equals the required return.

When picking investments, there are other factors to consider besides the predicted return of an investment above the risk-free rate of return. This is why the SML may be valuable for assessing and comparing securities, but it should be used in collaboration.

Making Use of the Security Market Line

Money managers and investors often use the security market line to assess an investment product they consider adding to a portfolio. The SML might be helpful when evaluating a security’s predicted return based on its degree of risk.

Plotting a security on the SML chart and having it appear above the SML implies that the security is undervalued since its location on the chart suggests that it delivers a higher return relative to its inherent risk.

On the other hand, if the security falls below the SML, its price is deemed excessive since the predicted return isn’t high enough to offset the risk.

When comparing two comparable securities with the same return, the SML is often used to identify which one has the lowest inherent market risk about the projected return. To determine which security offers the highest expected return relative to that degree of risk, securities with equal risk can also be compared using the SML.

Conclusion

• The securities market line (SML) is a line on a chart that graphically represents the capital asset pricing model (CAPM).
• The SML might be helpful when evaluating an investment product’s potential return on its risk profile.
• Return = risk-free rate of return + beta (market return minus the risk-free rate of return) is the formula used to depict the SML.