Question

1. Please describe the Security Market Line (SML).  Assets or portfolios that have risk-adjusted returns that are different from those on the SML will converge on the SML?  Why?  Please give two examples.

Answer 1

security market line

IT IS A RELATIONSHIP BETWEEN CAPITAL ASSETS PRICING MODEL AND BETA.

Security Market Line Equation

The Equation is as follows: SML: E(R_i) = R_f + β_i [E(R_M) – R_f] In the above security market line formula: E(R_i) is the expected return on the security.

The Security Market Line: This is an example of a security market line graphed. The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

Security market line (SML) is the graphical representation of the Capital Asset Pricing Model (CAPM) and gives the expected return of the market at different levels of systematic or market risk. It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets and y-axis represents the expected return.

The concept of beta is central to the CAPM and the SML. The beta of a security is a measure of its 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 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 the 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 undervalued because the position on the chart indicates that the security offers a greater return against its inherent risk. Conversely, if the security plots below the SML, it is considered overvalued in price because the expected return does not overcome the inherent risk.

The SML 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 expected return against that level of risk.