Portfolio Management - The Security Market Line (SML)
The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta.
The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line.
Figure 17.1: Security Market Line
Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium required by investors was to change, the slope of the SML would change as well.
When a shift in the SML occurs, a change that affects all investments' risk versus return profile has occurred. A shift of the SML can occur with changes in the following:
- Expected real growth in the economy.
- Capital market conditions.
- Expected inflation rate.