Security Market Line - SML Mean?

A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky
marketable securities. Also refered to as the "characteristic line".

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk
(beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected
return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A
security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk
assumed.

In Modern Portfolio Theory, the Security Market Line (SML) is the graphical representation of the Capital Asset Pricing
Model. It displays the expected rate of return for an overall market as a function of systematic, non-diversifiable
risk (its beta).
The Y-Intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the Market Risk
Premiumand reflects investors' degree of risk aversion at a given time.
When used in portfolio management, a single asset is plotted against the SML using its own beta and historical rate of
return. If the plot of the asset falls above the SML it is considered to have a good rate of return relative to its risk (the asset
is undervalued by the CAPM, and should be acquired), and vice versa if it falls below (the asset is overvalued, and should
be sold

The relationship between systemic risk and the expected return of an investment, depicted graphically. On the horizontal
axis are the betas of the companies in the market and on the vertical axis are the required rates of return listed as a
percentage. The return on the security market line says that the return on a security is equal to the risk-free rate of return
plus the excess return on the market portfolio times the beta of the security

The risk-return relationship of an efficient portfolio is measured by the capital market line. All portfolios other than efficient
portfolios will lie below the CML. The CML does not describe the risk – return relationship of inefficient portfolios of
individual securities. The CAPM specifies the relationship between expected return and risk for all securities and all
portfolios, whether efficient of inefficient.
We have seen earlier that the total risk of a security as measured by standard deviation is composed of two
components; systematic risk & unsystematic risk of diversifiable risk. As Investment is diversified and more and more
securities are added to a portfolio, unsystematic risk tends to become zero and the only relevant risk is systematic risk
measured by Beta (β). Hence it is argued that, the correct measure of security risk is beta. The beta analysis is useful for
individual securities and portfolios whether efficient of inefficient.
The relationship between expected return and β of a security can be determined graphically. Lit us consider an XY
graph where the expected returns are plotted on the OY axis and beta coefficient on OX axis. A risk free asset has expected
return equivalent to Rf and beta co – efficient is zero (0). The Market Portfolio M has a beta co – efficient of I and expected
return equivalent to Rm. A straight line joining these tow point is known as the Security Market Line (SML). The SML
helps to determine the expected return for a given security beta. This is explained in the following figure.
The Security Market Line provides the relationship between the expected return and beta of a security or portfolio. This
relationship can be expressed in the form of the following equation.
E(Rj) = Rf + βi [ E(Rm) – Rf ]