Security Market Line (SML)
The SML is a graphical representation of CAPM, plotting expected return against systematic risk (beta), with the line starting at risk-free rate and sloping upward by the market risk premium.
Concept map
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Definition
The SML is a graphical representation of CAPM, plotting expected return against systematic risk (beta), with the line starting at risk-free rate and sloping upward by the market risk premium.
Use case
Used in portfolio management workflows, analysis, and technical interviews.
Judgment check
Useful only when the assumptions and inputs behind the metric are understood.
Deep dive
How to think about Security Market Line (SML)
Assets plotting above the SML are undervalued (offering excess return for their risk); below are overvalued. The slope represents the market risk premium. The SML is used for security selection, capital budgeting hurdle rates, and performance evaluation. It's a cornerstone of modern financial theory.
Example: Risk-free = 3%, Market return = 10%. SML equation: Expected Return = 3% + Beta × 7%. Stock with beta 1.5 should return 13.5% per SML. If it's priced to return 15%, it plots above SML — attractive. Expected return of 12% plots below — unattractive.