# Security Market Line

Topics: Capital asset pricing model, Modern portfolio theory, Risk Pages: 7 (2187 words) Published: December 19, 2012
Security Market Line
In Markowitz Portfolio Theory, a line on a chart representing the capital asset pricing model. The security market line plots risk versus expected return of the market. The security market line is a useful tool in determining whether a given security is undervalued and/or a market outperform. If a security plots the security market line, it indicates a higher expected return for a given level of risk than the market as a whole.

security market line
A line used to illustrate the relationship between risk and return for individual securities. The security market line shows a positive linear relationship between returns and systematic risk as measured by beta.

Security Market Line (SML)
What Does Security Market Line (SML) Mean?
Security market line (SML) is the representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (itsbeta).[1] Investopedia explains Security Market Line (SML)

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. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for its risk. Individual securities are plotted on the SML graph. If a 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.

There is a question about what the SML looks like when beta is negative. A rational investor will accept these assets even though they yield sub-risk-free returns, because they will provide "recession insurance" as part of a well-diversified portfolio. Therefore, the SML continues in a straight line whether beta is positive or negative.[3] A different way of thinking about this is that the absolute value of beta represents the amount of risk associated with the asset, while the sign explains when the risk occurs.[4] Beta

The measure of an asset's risk in relation to the market (for example, the S&P500) or to an alternative benchmark or factors. Roughly speaking, a security with a beta of 1.5, will have move, on average, 1.5 times the market return. [More precisely, that stock's excess return(over and above a short-term money market rate) is expected to move 1.5 times the marketexcess return).] According to asset pricing theory, beta represents the type of risk,systematic risk, that cannot be diversified away. When using beta, there are a number of issues that you need to be aware of: (1) betas may change through time; (2) betas may be different depending on the direction of the market (i.e. betas may be greater for down moves in the market rather than up moves); (3) the estimated beta will be biased if the security does not frequently trade; (4) the beta is not necessarily a complete measure of risk (you may need multiple betas). Also, note that the beta is a measure of co-movement, not volatility. It is possible for a security to have a zero beta and higher volatility than the market

Beta
A measure of a security's or portfolio's volatility. A beta of 1 means that the security or portfolio is neither more nor less volatile or risky than the wider market. A beta of more than 1 indicates greater volatility and a beta of less than 1 indicates less. Beta is an important component of the Capital Asset Pricing Model, which attempts to use volatility and risk to estimate expected returns.

Beta
What Does Beta Mean?
A statistical measure of the volatility of an investment in relation to the market as a whole; also known as “beta coefficient” or “systematic risk.” Investopedia...

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