Question

Briefly discuss the concept of the Security Market Line (SML), and explain why all assets must plot

directly on it in a competitive market.

Answer 1

Security Market Line

A graphical representation of CAPM is the security market line,(SML). This line indicates the rate of return required to compensate at a given level of risk. Plotting required return on Y-axis and beta on the X-axis we get an upward sloping line which is given by (Rm-Rf), the risk premium.It work on a basic assumption that the investors need to be compensated for both time value of money and the corresponding risk referred to as risk premium.

The higher the beta value of a security, the higher would be the risk premium relative to the market. This upward-sloping line is called as security market line.It measures the relationship between systematic risk and return.

explain why all assets must plot directly on it in a competitive market.?

Let's understand this by way of an example, suppose the same item is available at different name A & B at different prices. A is priced more than B.Gradually Demand for Product B will increase since they are the same item with same quality and at a certain stage price of B will be more than the price of A.This buying and selling would continue until the two assets plotted on exactly the same line, which means they would offer the same reward for bearing the risk and will be plotted directly.