Security Market Line: Meaning, Equation, Features & Assumptions
Every investment that you undertake comes with some sort of risk. You can measure risks using several technical tools, allowing you to make wise decisions as per your risk appetite.
The security market line is one such tool that serves as a visual representation of the Capital Asset Pricing Model (CAPM), which is a model to measure risks vs return of an investment. The security market line describes the relationship between potential returns from an investment and the level of risk coming with that. In this article, we will delve a bit deeper into this concept and see how it works.
What Is a Security Market Line (SML)?
The SML is a line drawn on a chart that works like a graphical or pictorial depiction of the CAPM. This model depicts different levels of systematic risks of various assets or marketable securities plotted against corresponding potential returns that you may earn from them at a particular time span.
In this chart, the X-axis represents the level of systematic risk. Furthermore, the Y-axis represents the expected return at a particular level of risk. Many experts also call the SML a characteristic line.
The primary objective behind drawing these lines is to get an idea regarding whether any particular investment will be offering a favourable return with respect to its corresponding levels of risk.
What Is the Equation of the Security Market Line?
The equation of the security market line is as follows:
Security market line:
E(Ri) = Rf + βi [E(Rm) – Rf];
E(Ri) = Expected returns that you can earn from the investment;
Rf = Risk-free interest rates, and it is also the intercept of the y-axis;
βi = The amount of systematic risk in an investment and is one of the most critical components of this equation;
E(Rm) = Expected return of the market;
E(Rm) – Rf = This component represents the risk premium.
How to Interpret the Security Market Line?
In normal situations, a security with a high level of systematic market risk will require higher rates of returns as compensation for the same. The positioning of the security with respect to the security market line will determine whether one should purchase that security or not.
If such security is positioned above the corresponding security market line, it means that there is undervaluation in that asset. On the other hand, if the position of any asset is below the SML, it signals overvaluation in that particular asset.
Hence, we can safely conclude that any security whose position is above the SML will offer higher returns than expected at the same level of systematic risk. In contrast, all securities positioned under this particular line will give lower returns than expected returns derived from the CAPM.
Also Read: What is a Shareholders’ Agreement?
What Are the Features of the Security Market Line?
Some features of this line are as follows:
- Many experts consider it an ideal representation of investment opportunity costs. This is because it perfectly combines investment portfolios and risk-free assets.
- The slope of this curve is dependent on the market risk premium. The higher the premium amount, the steeper the slope will be. On the other hand, a lower premium amount will lead to a flatter slope.
- The zero beta assets come with a risk-free interest rate. Generally, returns of government bonds are considered risk-free.
What Are the Assumptions of Security Market Line?
As we have already discussed above, the security market line is a graphical representation of the CAPM. Therefore, it is obvious that the assumptions of this model will also stand true for the security market line.
CAPM is a variable model, and it considers only the level of risk that a security is exposed to. Here are some assumptions associated with the CAPM and the SML:
- There is no chance of any short sales.
- The timeline for investment is the same for all investors.
- There are multiple high-risk assets.
- All market participants behave in a rational manner.
- Every market participant that we consider in this model is a price taker. They have no authority to influence the price of such assets.
- No costs or taxes are applicable on such transactions.
Studying the security market line is an ideal way of determining the returns of a particular asset. It is nothing but a graphical or visual representation of the capital asset pricing model. If you are looking to invest in any security, you should compare its risks and your own risk appetite before taking any decision.
Frequently Asked Questions
What are the various components of the security market line?
The various components of this line are beta, which is the risk of the asset, expected market returns, and prevailing risk-free interest rates.
What are the advantages of the security market line?
It is a straightforward model which you can use to determine the potential returns of a security at various levels of risk. Moreover, this concept allows the comparison of diversified portfolios because of the consideration of systematic risks.
What are the drawbacks of security market lines?
One of the major drawbacks of this line is that expected market returns are based on past performance. You cannot directly extrapolate the same for the future.
What is the difference between the security market line and the capital market line?
One of the significant differences between these two concepts is that SML depicts the risk and expected returns of a single security. On the other hand, the capital market line depicts the risk and return trade-off of the entire investment portfolio.