What is the security market line? IIFL Knowledge Center

what is security market line
what is security market line

The CML, therefore, plays a part in assisting investors decide the proportion of their funds that should be invested in the different risky and risk free assets. Examples for risk free assets include treasury bills, bonds, and government issued securities, whereas risky assets can include shares, bonds, and any other security issued by a private organization. It is a graphical representation of Capital Asset Pricing Model . It helps to determine the risk premium which is a difference of market return and risk free rate. It is a risk and return trade-off where systematic risk are plotted against an individual security in a graph at a given point of time. It helps to determine whether the security is overvalued or undervalued.

The placement of the security relative to the security market line determines whether it is undervalued, valued fairly, or overvalued. Market IndexA market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by listing the historical and real-time trends in different market segments. Factors such as inflation or deflation, economic and political changes, or other macroeconomic factors such as unemployment can cause the slope of the SML to change or shift with time. Therefore, the advantages and limitations of SML are the same as that of the CAPM. The securities that appear on the left side of the SML are considered undervalued .

what is security market line

Additionally, a beta higher than 1 suggests the security’s return is greater than the market as a whole. Beta is a measure of volatility or systematic risk or a security or a portfolio compared to the market. The market can be considered an indicative market index or a basket of universal assets.

What are the advantages of the security market line?

Suppose the risk-free rate on an investment is 5% and that the expected market return is 20%. SML helps investors in the proper evaluation and assessment of assets. Every investment has some risks inherent in them and these risks combine to determine the expected return. The security market line is a positively sloped line displaying the relationship between the required return from security for each given level of non-diversifiable risk. It is the rate of return available in the present scenario for various types of securities under consideration.

what is security market line

Beta (β) → The non-diversifiable risk resulting from market volatility (i.e. the systematic risk) of a security relative to the broader market (S&P 500). The required rate of return, or “discount rate“, is one of the primary determinants that guide the decision-making process of an investor on whether to invest in the security. Several different exogenous variables can impact the slope of the security market line. For example, the real interest rate in the economy might change; inflation may pick up or slow down; or a recession can occur and investors become generally more risk-averse. It is rare that any market is in equilibrium, so there may be cases where a security experiences excess demand and its price increases belong where CAPM indicates the security should be.

Difference Between Capital Market Line (CML) and Security Market Line (SML)

The plotting of the return an investor expects from security is done on the y-axis. If the security is plotted above the SML, it is said to be undervalued. The reason for the interpretation is that if the security falls above the SML, the security provides a higher return for a given level of risk implying that opportunity is not yet exploited by the market.

The price of the asset is too high, which eats away at the returns the asset provides and thus, causes the asset to be plotted below the security market line. Market risk premium is the difference between what is security market line the expected return on a market portfolio and the risk-free rate. The security market line is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model .

Suppose the risk-free rate of return is 6%, the expected rate of return on the market is 15 percent, the beta of asset A is 0.5 and the beta of asset B is 1.5. Thus security B has higher expected returns because it has a higher beta and hence, is riskier than security A. Similarly, if the security is plotted below the SML, it is said to be overvalued giving lower returns than the market for a given level of risk. Risk can be defined, generally, as the potential that a chosen action or activity will lead to a loss or an undesirable outcome. The concept of risk implies that choice has an influence on the outcome. More specifically to finance, risk can be seen as relating to the probability of uncertain future events.

As a result, deviations from the SML are potentially more accurate indicators of opportunities for profitable trades than in the past. Theoretically, a risk taken above the market average should result in a higher return to compensate the investor for the risk taken, which is why the SML shows a positive relationship . It is as analogous to the investor receiving apremiumfrom the company for accepting the additional risk. Is part of the IIFL Group, a leading financial services player and a diversified NBFC. The site provides comprehensive and real time information on Indian corporates, sectors, financial markets and economy. On the site we feature industry and political leaders, entrepreneurs, and trend setters.

In turn, desirability increases the demand and eventually the ultimate price of the stock. When the price rises, the result is a decrease in its expected return. This brings its position back down closer to the security market line.

What Is the Security Market Line?

If an asset is plotted below the security market line it is overpriced and vice versa. The reason behind it is that the asset is giving a return lower than the market average due to the cost of buying the asset being too large. Since the return on an asset is directly proportional to the price of the asset – this means the asset is overpriced and must be reduced in price to re-approach the market average. An example of such risk can be those due to war-like situations, geo-political issues, health crises and more, things that we have experienced recently.

Graph of SML

One of the major drawbacks of this line is that expected market returns are based on past performance. The security market line is one such tool that serves as a visual representation of the Capital Asset Pricing Model , 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. The larger the level of systematic risk, the larger the expected return for the security is – more risk equals more reward.

In this exercise, we have the expected rate of return for all the available securities. And after that, according to the gap/difference in the returns, the beta calculation and ranking happen. Then finally, based on the risk appetite and portfolio composition, the securities for investment purpose is identified. The graph’s X-axis has systematic risk, which is measured by beta, while the expected returns are on the Y axis. This is the part of the risk explained by a company’s exposure to market factors i.e. interest rates, economic growth, etc. It might be noted that the CAPM and therefore the SML is based on the idea that only systematic risk should affect asset prices.

The security market is the representation of the CAPM model in a graphical format. The Y axis represents the level of expected return, and the X axis shows the level of risk represented by beta. Any security that falls on the SML itself is considered to be valued fairly so that the level of risk corresponds to the level of return. Any security that lies above the SML is an undervalued security as it offers greater return for the risk incurred. Any security below the SML is overvalued as it offers less return for the given level of risk. The Capital Asset Pricing Model is graphically represented by drawing the Security Market Line.

Hence, the SML graph plots the systematic risks of an investment – usually measured by beta – against its expected return. If an asset plots above the SML, the asset is said to be underpriced/undervalued. Thus, a prudent investor will want returns from his investment because of the risk he undertakes on his investment. His money has an opportunity cost- he can invest it in other avenues other than the current security investment option and still generate returns.

If you are looking to invest in any security, you should compare its risks and your own risk appetite before taking any decision. CML is used to see a specific portfolio’s rate of return while the SML shows a market risk and a given time’s return. Fundamentally, a higher degree of systematic risk (i.e. undiversificable, market risk) in a security should result in investors requiring a higher rate of return as compensation for the greater level of risk.

Now, since the required return of stock A (i.e. 15.80%) is greater than the forecasted return (12.0%) on the same, this stock is overvalued. The Security Market Line is a graphical representation of the Capital Asset Pricing Model and shows the expected return for an asset, for each level of risk. CML is the graphical presentation of the equilibrium relationship between expected return and total risk for efficiency diversified portfolios. SML is a good representation of investment opportunity cost, which combines the risk-free asset and the market portfolio.

If the price of the asset is too high, it eats into the returns the asset provides. Therefore, the asset should appear below the security market line. The Efficient Market Theory asserts that stocks that appear above the SML are desirable.

Consequently, it aligns with the general finance theory of higher risk and higher expected return. The expected return for Security A as per the security market line equation is as per below. All of the portfolios on the SML have the same Treynor ratio as does the market portfolio, i.e. If there is an increase in inflation, investors may get more risk-averse over a stock. The SML is mostly used by investors during the evaluation of securities. It is used to assess prospective investment products to decide whether to include them in an investment portfolio.

Factors that cause such a risk can be economical and policy changes, interest rates, political disturbances, natural calamities, etc. The slope of the SML shows the differences between the required rate of return on the market index and the risk-free rate. The slope of the CML shows the market price of risk for efficient portfolios. All market investors are risk-averse and they cannot affect the price of a security. On the other hand, if the security is below the SML, it would be deemed overvalued since lower returns are anticipated while still being exposed to a greater level of risk. Generally speaking, the return on the market (S&P 500) has historically been around ~10% while the equity risk premium normally ranges between 5% to 8%.

The risk in these individual risky securities reflects the systematic risk. The security market line can help clarify whether an asset is overpriced or underpriced. Of course, given its level of systematic risk compared to the market. When a stock or security is plotted on the SML chart it is considered undervalued if it appears above the SML. Conversely, if the security plots below the SML, it is considered overvalued in price. This is because the expected return does not overcome the inherent risk.

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