Security market line

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 risk of an individual risky security reflects the volatility of the return from the security rather than the return of the market portfolio. The risk in these individual risky securities reflects the systematic risk.^[1]

Formula

The Y-intercept of the SML is equal to the

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.^[2] In a market in perfect equilibrium, all securities would fall on the SML.

There is a question about what the SML looks like when beta is negative. A

All of the portfolios on the SML have the same Treynor ratio as does the market portfolio, i.e.

${\displaystyle {\frac {E(R_{i})-R_{f}}{\beta _{i}}}=E(R_{M})-R_{f}.}$

In fact, the slope of the SML is the Treynor ratio of the market portfolio since ${\displaystyle \beta _{M}=1}$.

A

This abnormal extra return above the market's return at a given level of risk is what is called the

See also

• Capital allocation line
• Capital market line
• Efficient frontier
• Market portfolio
• Modern portfolio theory
• Security characteristic line

References