What is a Characteristic Line
A characteristic line is a line formed using regression analysis that summarizes a particular security's systematic risk and rate of return. The characteristic line is created by plotting a security's return at various points in time. The y-axis on the chart measures the excess return of the security. Excess return is measured against the risk-free rate of return. The x-axis on the chart measures the market's return in excess of the risk free rate.
The security's plots reveal how the security performed relative to the market in general. The regression line formed from the plots will show the security's excess return over the measured period of time as well as the amount of systematic risk the security demonstrates. The y-intercept is the security's alpha. The slope of the characteristic line is the security's systematic risk, or beta.
The characteristic line is also known as the security characteristic line (SCL).
BREAKING DOWN Characteristic Line
The characteristic line is part of a wider suite of security and market performance assessment tools known as Modern Portfolio Theory (MPT). In addition to the characteristic line regression, other qualities of a security or the overall market can be plotted and regressed to help an investor measure risk and make decisions. Other analytic tools in the Modern Portfolio Theory family are the security market line (SML), the capital market line (CML), the capital allocation line (CAL) and the capital asset pricing model (CAPM). All of these systems use various constructions of risk, excess return, overall market performance, security beta, and individual security performance to assess the risk/return tradeoff and inform investment decisions.