A visual representation of the capital asset pricing model (CAPM)
Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
What is the Security Market Line (SML)?
The security market line (SML) is a visual representation of the capital asset pricing model (CAPM). SML is a theoretical representation of the expected returns of assets based on systematic, non-diversifiable risk.
Idiosyncratic risk is not included in the security market line. More broadly, the SML plots the expected market returns for a marketable security at a given level of market risk for the marketable security. The level of risk is determined by the beta of a security against the market.
Theoretically, the “market” refers to all risky assets. In practice, a proxy is typically used. An example of common proxies is the Dow Jones Industrial Average (DJIA), , and the NASDAQ 100. The security market line can also be used to graphically understand the pricing of an asset. However, the security market line is not always applicable in practice, as there are very broad assumptions involved that do not always apply.
Security Market Line Assumptions
Since the security market line is a graphical representation of the capital asset pricing model (CAPM), the assumptions for CAPM also hold for SML. Most commonly, CAPM is a one-factor model that is only based on the level of systematic risk a security is exposed to.
The larger the level of systematic risk, the larger the expected return for the security is – more risk equals more reward. It is a linear relationship and explains why the security market line is a straight line. However, very broad assumptions need to be made for a one-factor model to be upheld. Below are some SML assumptions:
- All market participants are price takers and cannot affect the price of a security.
- The investment horizon for all investors is the same.
- There are no short sales.
- There are no taxes or transaction costs.
- There is only one risk-free asset.
- There are multiple risky assets.
- All market participants are rational.
Components of the SML
The security market line is made up of the risk-free rate, the beta of the asset related to the market, and the expected market risk premium. The components will yield the expected return of an asset. Additionally, the SML formula can be used to calculate the asset’s risk premium. Below is the formula to calculate the security market line:
Security Market Line = Risk-Free Rate + [Beta * (Expected Market Return – Risk-Free Rate)]
Where:
- Risk-Free Rate – Current risk-free rate
- Beta – Beta of the security to the market
- Expected Market Return – Expected return of all risky assets
Plotting the function for all positive betas, with the constraint of a positive market risk premium (Expected Market Return – Risk-Free Rate), will give the typical security market line. To get the expected risk premium of a security, subtract the first risk-free rate from both sides of the equation. It will produce:
Expected Security Risk Premium = Beta * (Expected Market Return – Risk-Free Rate)
SML and Asset Pricing
The security market line can also be used to determine whether an asset is overpriced or underpriced, given its level of systematic risk, compared to the market. Graphically, if the asset offers a return that is higher than the market’s for a given level of systematic risk, it will be plotted above the security market line. However, if the asset offers a return that is lower than the market’s for a given level of systematic risk, it will be plotted below the security market line.
If an asset is plotted above the security market line, it is underpriced. If an asset is plotted below, it is overpriced. The intuitive reason why an asset that is plotted above the SML is underpriced is that it is giving a return larger than the market, and it is because the cost of buying the asset is not large enough. The return of an asset is directly related to the price at which the asset is bought. Thus, with the security market line, if an asset is providing too large of a return, it means that it is underpriced.
The same intuition holds for when an asset is overpriced. The price of the asset is too high, which eats away at the returns the asset provides and thus, causes the asset to be plotted below the security market line. With the Efficient Market Theory, assets that are plotted above the SML are bought, which increases the demand and the price of the asset, thus decreasing its expected return and bringing it back down to the security market line.
More Resources
Thank you for reading CFI’s guide on Security Market Line (SML). To keep advancing your career, the additional resources below will be useful:
- Beta
- Expected Return
- Idiosyncratic risk
- Market Risk Premium
- See all wealth management resources
FAQs
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). The SML can help to determine whether an investment product would offer a favorable expected return compared to its level of risk.
What is SML in cyber security? ›
The security market line (SML) is a visual representation of the capital asset pricing model (CAPM). SML is a theoretical representation of the expected returns of assets based on systematic, non-diversifiable risk. Idiosyncratic risk is not included in the security market line.
What is the SML and CML line? ›
Capital Market Line vs.
The CML is sometimes confused with the security market line (SML). The SML is derived from the CML. While the CML shows the rates of return for a specific portfolio, the SML represents the market's risk and return at a given time and shows the expected returns of individual assets.
What is the difference between CAPM and SML? ›
The CAPM is a formula that yields expected return. Beta is an input into the CAPM and measures the volatility of a security relative to the overall market. SML is a graphical depiction of the CAPM and plots risks relative to expected returns.
How to interpret SML? ›
Any security plotted above the SML is interpreted as undervalued. A security below the line is overvalued. Fundamental analysts use the CAPM as a way to spot risk premiums, examine corporate financing decisions, spot undervalued investment opportunities and compare companies across different sectors.
What are the uses of SML? ›
Standard ML (SML) is a general-purpose, high-level, modular, functional programming language with compile-time type checking and type inference. It is popular for writing compilers, for programming language research, and for developing theorem provers.
What does SML mean? ›
SML is an online and texting acronym that means various things. It can mean screw my life, so much love, or sometimes so much laughter. Related words: SOML.
What are the basics of SML? ›
The syntax of SML is simple and natural, and it emphasizes the underlying meaning of the code. The fundamental syntactic entity is the expression, which specifies a value. Expressions An expression is composed of identifiers, constants, and operators. Parentheses may be used for grouping.
What is SML in networking? ›
The Service Metadata Locator (SML) is the key component that enables dynamic discovery of participants in message exchange networks. As a result, these networks can scale up without being affected by the management of an increasing number of participants.
What are the main differences between CML and SML? ›
Unlike the SML, which focuses solely on individual assets, the CML incorporates the concept of diversification by combining a risk-free asset with a portfolio of risky assets. The risk-free asset is typically represented by government bonds, which are considered to have negligible default risk.
The Y-intercept of the SML is equal to the risk-free interest rate. Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
What does SML slope mean? ›
The slope of the security market line (SML) is the reward-to-risk ratio, which equals the difference between the expected market return and risk-free rate (rf) divided by the beta of the market.
What does the security market line show? ›
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.
Do people still use CAPM? ›
Despite its issues, the CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives. For instance, it is used in conjunction with modern portfolio theory (MPT) to understand portfolio risk and expected return.
Why is CAPM so popular? ›
The CAPM is a widely-used return model that is easily calculated and stress-tested. It is criticized for its unrealistic assumptions. Despite these criticisms, the CAPM provides a more useful outcome than either the DDM or the WACC models in many situations.
What does the slope of the SML represent? ›
The slope of the security market line (SML) is the reward-to-risk ratio, which equals the difference between the expected market return and risk-free rate (rf) divided by the beta of the market.
What does the security market line depict in Quizlet? ›
What does the security market line depict? -It depicts the relationship between systematic risk and unsystematic risk.
What does the slope of the security market line SML represents the portion of an asset's expected return attributable to? ›
Answer : B is correct. The slope of the SML is the market risk premium, E(Rm) - Rf. It represents the return of the market minus the return of a risk-free asset. Thus, the slope represents the portion of expected return that reflects compensation for market or systematic risk.
What is SML value? ›
Mean sea level (MSL, often shortened to sea level) is an average surface level of one or more among Earth's coastal bodies of water from which heights such as elevation may be measured.
