What Is the Security Market Line?

The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the 澳洲幸运5官方开奖结果体彩网:capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of various 澳洲幸运5官方开奖结果体彩网:marketable securities, plotted against the 澳洲幸运5官方开奖结果体彩网:expected return of the entire market at any given time.

Also known as the "澳洲幸运5官方开奖结果体彩网:characteristic line," the SML is a visualization of the CAPM, where the x-axis of the chart represents risk (in terms of beta), and the y-axis of the chart represents expected return. The 澳洲幸运5官方开奖结果体彩网:market risk premium of a given security is determined by where it is plotted on the chart relative to the SML.

Understanding the Security Market Line

The security market line is an investment evaluation tool derived from the CAPM—a model that describes the 澳洲幸运5官方开奖结果体彩网:risk-return relationship for securities—and is based on the assumption that investors need to be compensated for both the 澳洲幸运5官方开奖结果体彩网:time value of money (TVM) and the corresponding level of risk associated with any investment, referred to as the 澳洲幸运5官方开奖结果体彩网:risk premium. Interpreting the 澳洲幸运5官方开奖结果体彩网:information from an SML graph helps analysts understand market risks.

The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of its 澳洲幸运5官方开奖结果体彩网:systematic risk, which cannot be eliminated by diversification. A beta value of one is considered as the overall market average. A beta value that's greater than one represents a risk level greater than the market average, and a beta value of less than one represents a risk level that is less than the market average.

The formula for plotting the SML is:

• Required return = risk-free rate of return + beta (market return - risk-free rate of return)

Using the Security Market Line

The security market line is commonly used by money managers and investors to evaluate an investment product that they're thinking of including in a portfolio. The SML is useful in determining whether t🐠he security offers a favorable expected return compared to its level of risk.

When a security is plotted on the SML chart, if it appears above the SML, it is considered 澳洲幸运5官方开奖结果体彩网:undervalued because the position on the chart indicates that the security offers a greater return against its 澳洲幸运5官方开奖结果体彩网:inherent risk.

Conversely, 🔯if the security plots below the SML, it is considered overvalued in price because the expected return does no💮t overcome the inherent risk.

The S🐓ML is frequently used in comparing two similar securities that offer approximately the same return, in order to determine 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 expec🌼ted return against that level of risk.