What Is the Security Market Line?
The security market line (SML) is a theoretical representation of the expected returns of assets based on systematic, non-diversifiable risk.
The security market line (SML) is a line investors calculate and plot on a trading chart. It serves as a graphical representation of the capital asset pricing model (CAPM). The CAPM shows different levels of systematic or market risk, of various marketable securities. These returns are plotted against the expected return of the entire market at any given time.
SML is also known as the characteristic line. The x-axis of the chart represents the risk in terms of beta. The y-axis of the chart represents the expected return. The market risk premium of a given security is determined by where it is plotted on the chart relative to the SML.
Security Market Line – A Closer Look
The security market line is an investment evaluation tool derived from the Capital Asset Pricing Model (CAPM). The CAPM model describes the risk-return relationship for securities. It assumes that investors need compensation for the time value of money (TVM). It further assumes additional compensation for the level of risk associated with any investment. This additional risk is referred to as the risk premium. The security market line (SML) is a line plotted on a chart. This chart then serves as a graphical representation of the capital asset pricing model (CAPM). The SML can help to determine whether an investment offers a favorable expected return compared to its level of risk.
The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of its systematic risk. This is a type of risk an investor cannot eliminate through diversification. Investors consider a beta value of one as the overall market average. A beta value that is greater than one represents a risk level greater than the market average. A beta value of less than one represents a risk level that is less than the market average. The SML can be a valuable tool for evaluating and comparing securities. However, it should not be used in isolation. The expected return of an investment over the risk-free rate of return is not the only thing to consider when choosing investments. (Source: investopedia.com)
Understanding the Security Market Line and Risk
A certain amount of risk is inherent in any investment. Risk can be defined, generally, as the potential that a chosen action or activity will lead to a loss or an undesirable outcome. The concept of risk implies that choice has an influence on the outcome. More specifically to finance, risk can be seen as relating to the probability of uncertain future events. In return for undertaking risk, investors expect to be compensated in such a way as to reasonably rewarding them. This is a central theme in the subject of finance. In the financial realm, two types of risk exist – systematic and unsystematic.
- Systemic risk is the risk associated with an entire financial system or the entire market. This type of risk is inherent in all marketable securities and cannot be diversified away.
- Unsystematic risk is a risk to which only specific classes of securities or industries are vulnerable. This type of risk is uncorrelated with broad market returns. With a proper grouping of assets can be reduced or even eliminated. Because of this characteristic, investors are not rewarded for taking on unsystematic risk.
What is Beta?
Systematic risk can be understood further using the measure of Beta. This is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to — usually the market as expressed in an index. (Source: lumenlearning.com)
Security Market Line Assumptions
The security market line is a graphical representation of the capital asset pricing model (CAPM). Therefore, the assumptions for CAPM also hold for SML. Most commonly, CAPM is a one-factor model. It is only based on the level of systematic risk the security is exposed to.
More risk equals more reward. The larger the level of systematic risk, the larger the expected return for the security. 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 consistent. 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.
- No short sales.
- No taxes or transaction costs.
- There is only one risk-free asset.
- There are multiple risky assets.
- All market participants are rational.
How To Calculate the Security Market Line
The security market line is made up of three components. The risk-free rate, the beta of the asset related to the market, and the expected market risk premium. These values 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:
Required Return = Risk-free Rate + Beta [(Expected Market Return) – Risk-free Rate]
- Risk-Free Rate – Current risk-free interest rate
- Beta – Beta of the security compared to the market
- Expected Market Return – The expected return of all market assets
Security Market Line Calculation Example
Assume the risk-free rate is 4%, and the expected market return is 12%. Next, consider two securities. Security A has a beta coefficient of 0.5. Security B has a beta coefficient of 1.5 with respect to the market index. Now let’s understand the security market line by calculating the expected return for each security.
The expected return for Security A as per the security market line equation is:
- Expected Return = Riskfree Rate + Beta [(Expected Market Return) – Riskfree Rate]
- ER = 4 + 0.5 [12 – 4]
- ER = 4 + 0.5 × 8 = 8.0%
Similarly, the expected return for Security B is:
- Expected Return = Riskfree Rate + Beta [(Expected Market Return) – Riskfree Rate]
- ER = 4 + 1.5 [12 – 4]
- ER = 4 + 1.5 × 8 = 16.0%
The result – Security A has a lower beta. Therefore, it has a lower expected return of 9.5%. Security B has a higher beta coefficient. As a result, it has a correspondingly higher expected return. These results are in line with the general finance theory and the Capital Asset Pricing Model (CAPM). Higher risk should be rewarded with a higher expected return.
How to Use the Security Market Line
The security market line is commonly used by money managers and investors. It is a tool used to evaluate an investment product they might want to include in a portfolio. The SML is useful in determining whether the security offers a favorable expected return compared to its risk level. The SML is frequently used in comparing two similar securities that offer approximately the same return. It helps clarify which of them involves the least amount of inherent market risk relative to the expected return. The SML can also be used to compare securities of equal risk to see which one offers the highest expected return against that level of risk.
Security Market Line and Asset Pricing
The security market line can help clarify whether an asset is overpriced or underpriced. Of course, given its level of systematic risk compared to the market. When a stock or security is plotted on the SML chart it is considered undervalued if it appears above the SML. Conversely, if the security plots below the SML, it is considered overvalued in price. This is because the expected return does not overcome the inherent risk. Put another way, 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. 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.
An asset that appears above the SML is considered underpriced. This is because it is giving a return larger than the overall market rate but the cost to buy it is too low. The return of an asset is directly related to the price at which an investor can purchase that asset. Using the security market line, if an asset provides too large of a return at too cheap a price, it is underpriced.
The same reasoning applies to an asset that is overpriced. If the price of the asset is too high, it eats into the returns the asset provides. Therefore, the asset should appear below the security market line. The Efficient Market Theory asserts that stocks that appear above the SML are desirable. In turn, desirability increases the demand and eventually the ultimate price of the stock. When the price rises, the result is a decrease in its expected return. This brings its position back down closer to the security market line.
The SML is a graphical representation of CAPM. Therefore, the advantages and limitations of SML are the same as that of the CAPM.
- Easy to use – SML and CAPM can be easily used to derive expected return from the assets or portfolio
- Assumes a diversified portfolio – The model assumes the portfolio is well diversified hence neglects the unsystematic risk making it easier to compare two diversified portfolios
- Weighs systematic risk – CAPM or SML considers the systematic risk, which is neglected by other models likes the Dividend Discount Model (DDM) and Weighted Average Cost of Capital (WACC) model.
- The risk-free rate is the yield of short-term government securities. However, the risk-free rate can change with time and can have an even shorter-term duration. This can cause volatility
- The market return is the long-term return from a market index. It includes both capital and dividend payments. The market return could be negative, which is generally countered by using long-term returns.
- Market returns are calculated from past performance, which cannot be taken for granted in the future.
- The slope of SML, i.e., market risk premium and the beta coefficient, can vary with time. There can be macroeconomic changes like GDP growth, inflation, interest rates, unemployment, etc. These factors can change the SML.
- The significant input of SML is the beta coefficient. However, predicting accurate beta for the model is difficult. Thus, the reliability of expected returns from SML is questionable. Particularly if proper assumptions for calculating beta are not considered. (Source: wallstreetmojo.com)
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