security market line
Presented by
Ujjayini Das
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security market line
• The security market line (SML) is the
representation of market equilibrium
• Security market line (SML) is the
graphical 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
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Two interpretation of SML
• Each asset may be viewed as a combination of risk-free
assets and market portfolio.
• Under equilibrium, all assets are plotted on the SML i.e.,
all the assets, which are priced correctly, lie on SML
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• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
• But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten
• Slope = E(RM) – Rf = market risk premium
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The Security Market Line
Consider a portfolio composed of the following two
assets:
• An asset that pays a risk-free return Rf, , and
• A market portfolio that contains some of every risky
asset in the market.
Portfolio E(R) Beta
Risk-free asset Rf 0
Market portfolio E(Rm) 1
Security market line: the line connecting the risk-free
asset and the market portfolio
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The Security Market Line
The Security Market Line shows how an investor can construct a
portfolio of T-bills and the market portfolio to achieve the desired
level of risk and return. Page 6 6
The Security Market Line and
the CAPM
The two-asset portfolio lies on security market line.
Given two points (risk-free asset and market portfolio
asset) on the security market line, the equation of the
line is:
E(Ri) = Rf + ß [E(Rm) – Rf]
Return for Portfolio’s Reward for
bearing no exposure to bearing market
market risk market risk risk
The equation represents the risk and return
relationship predicted by the Capital Asset Pricing
Model (CAPM). Page 7 7
The Security Market Line
Plots relationship between expected return and betas.
• In equilibrium, all assets lie on this line.
• If individual stock or portfolio lies above the line:
– Expected return is too high – stock is undervalued.
– for a given amount of risk (beta), they yield a higher return
– Investors bid up price until expected return falls.
• If individual stock or portfolio lies below SML:
– Expected return is too low – stock is overvalued.
– for a given amount of risk, they yield a lower return
– Investors sell stock driving down price until expected return
rises.
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The Security Market Line
E(RP)
A - Undervalued SML
•
•
A
RM • B • Slope = (y2-y1) / (x2-x1)
• = [E(RM) – RF] / (βM-0)
= [E(RM) – RF] / (1-0)
= E(RM) – RF
RF
• B - Overvalued = Market Risk Premium
•
M =1.0 i
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Required Return
• The return that a rational investor should
demand is therefore based on market rates and
the beta risk of the investment.
• To find this, solve for the required return in the
CAPM:
R (k ) R f s [k M R f ]
• This is a formula for the straight line that is the
SML.
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CML VS SML
• CML actually represents the expected
returns of the efficient portfolios as a
function of their volatility which is measured
by the standard deviation of their returns.
where as the SML represents the
expected returns of the individual assets as
a function of its sensitivity to market
fluctuations.
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• A rightly priced security will lie exactly on
SML.
• ALL the efficient portfolios of the CML lie
on the SML, BT the converse is not true.
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Thank you
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