Security Market Line - SML

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What is the 'Security Market Line - SML'

The security market line (SML) is 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 referred 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.

BREAKING DOWN 'Security Market Line - 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.

The SML demonstrates a linear relationship between anticipated asset returns as betas, as suggested by the capital asset pricing model (CAPM). A beta is a measure of the risk associated with a particular security as it relates to the market. A beta of one is considered to be market average, while a beta of 1.5 would represent a risk of one and a half times the market average. Betas are said to represent systematic risk which is considered undiversifiable.

The SML and Risk

The SML provides a way to compare the riskiness of a particular stock as compared to the overall market performance and is defined by the CAPM. The SML low point correlates to items considered zero risk, such as guaranteed bonds. The midpoint represents the current market performance average. The highest point denotes the highest risk.

The SML and Trade Decision Analysis

The SML provides a way for investors to determine if the amount of potential reward, based on anticipated returns, corresponds with the amount of risk involved with the particular security. In general, the higher the risk, the higher investors want the potential for returns to be, based on an assumed linear relationship between the two concepts.

When deciding between multiple securities with the same expected return, an investor may choose the one with the lowest risk necessary to achieve that return. If all risk is considered the equal, the choice would be based on which security provided the highest return.

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RELATED FAQS
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