Security Market Line

The security market line (SML) depicts the relationship between risk and expected rate of return on an asset. Using estimates for the rate of return on a risk-free asset and the market portfolio, while applying the asset's systemic risk generates a sequence of risk and return profiles for the security. Comparing this computed rate of return to with the estimated rate of return generates a buy or sell signal by determining if the asset is undervalued or overvalued.

The equation used in determining an asset's expected return is:

Expected return = Risk free rate + Beta (Return of the Market Portfolio - Risk Free Rate)

Beta in this case is the standardized value of systemic risk, calculated as covariance of the market portfolio divided by the variance of the market portfolio. Beta values above 1 indicate increased levels of risk while values below 1 suggest a lower risk profile.

Where the capital asset pricing model uses standard deviation as the risk measure, the securitiy market line employs beta to compensate for the market portfolio's covariance and variance. The graph is upward sloping, reflecting the relationship that lower risk levels provide lower returns compared with riskier assets.

Assets priced above the security market line are considered undervalued because the rate of return is greater than had been anticipated. Conversely, assets plotted below the security market line are considered overvalued because the rate of return will actually be lower than estimated.

In a perfectly efficient market, all assets lie on the SML. For those assets totally uncorrelated with the market, referred to as zero-beta portfolios, the slope of line through the market portfolio is less steep. An investor would choose zero-beta assets with minimum variance, and while such instruments have no systemic risk, they do have some unsystemic risk.

The SML assumes no transaction costs, heterogeneous risk/return expectations, similar time horizons, and is based on pretax returns.

Financial Terms by BetterTrades