Security Market Line (SML)

Youssef_Louraoui

In this article, Youssef Louraoui (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) presents the Security Market Line (SML), a key concept derived from the Capital Asset Pricing Model (CAPM).

This article is structured as follows: we introduce the concept. We then proceed with a presentation of the mathematical foundations of the concept, and we finish by presenting an investment strategy that can be implemented relying on the Security Market Line.

Security Market Line

The SML reflects the risk-return combinations accessible in the capital market at any given time for all risky assets. Investors would choose investments based on their risk appetites; some would only consider low-risk investments, while others would welcome high-risk investments. The SML is derived from the Capital Asset Pricing Model (CAPM), that describes the trade-off between risk and return for efficient portfolios.

The expected relationship between risk and return is depicted in Figure 1. It demonstrates that as perceived risk increases, investors’ required rates of return increase.

Figure 1. Security Market Line graph

SML_graph

Source: Computation by the author.

Mathematical foundation

Mathematically, we can deconstruct the Security Market Line as:

SML_formula

Where

  • E(Ri) represents the expected return of asset i
  • Rf is the risk-free interest rate
  • β measures the systematic risk of asset i
  • E(RM) represents the expected return of the market
  • E[RM – Rf] represents the market risk premium.

Beta and the market factor

William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966) independently developed the Capital Asset Pricing Model (CAPM). The CAPM was a significant evolutionary step forward in capital market equilibrium theory because it allowed investors to value assets correctly in terms of risk. The CAPM makes a distinction between two forms of risk: systematic and specific risk. Systematic risk refers to the risk posed by the market’s basic structure, its participants, and all non-diversifiable elements such as monetary policy, political events, and natural disasters. By contrast, specific risk refers to the risk inherent in a particular asset and so is diversifiable. As a result, the CAPM solely captures systematic risk via the beta measure, with the market’s beta equal to one, lower-risk assets having a beta less than one, and higher-risk assets having a beta larger than one.

In the late 1970s, the portfolio management industry sought to replicate the market portfolio return, but as financial research advanced and significant contributions were made, it enabled the development of additional factor characteristics to capture additional performance. This resulted in the development of what is now known as factor investing.

Estimation of the Security Market Line

You can download an Excel file with data to estimate the Security Market Line.

Download the Excel file to compute the Security Market Line

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in broadening your knowledge of finance.

Related posts on the SimTrade blog

   ▶ Louraoui Y. Portfolio

   ▶ Louraoui Y. Systematic and unsystematic risk

   ▶ Louraoui Y. Beta

   ▶ Louraoui Y. Factor Investing

   ▶ Louraoui Y. Origin of factor investing

   ▶ Louraoui Y. Markowitz Modern Portfolio Theory

   ▶ Walia J.Capital Asset Pricing Model (CAPM)

Useful resources

Academic research

Drake, P. and Fabozzi, F., 2010. The Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management. John Wiley and Sons Edition.

Lintner, J. 1965a. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics 47(1): 13-37.

Lintner, J. 1965b. Security Prices, Risk and Maximal Gains from Diversification. The Journal of Finance, 20(4): 587-615.

Mossin, J. 1966. Equilibrium in a Capital Asset Market. Econometrica, 34(4): 768-783.

Reilly, R. K., Brown C. K., 2012. Investment Analysis & Portfolio Management, Tenth Edition.

Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis. Management Science, 9(2): 277-293.

Sharpe, W.F. 1964. Capital Asset Prices: A theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3): 425-442.

About the author

The article was written in November 2021 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).

This entry was posted in Contributors, Financial techniques and tagged , , , , . Bookmark the permalink.

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