Security market line and capital market line

Security market line and capital market line

Security market line

In Modern Portfolio Theory, the Security Market Line (SML) is the graphical representation of the Capital Asset Pricing Model. It displays the expected rate of return for an overall market as a function of systematic (non-diversifiable) risk (beta).

The Y-Intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the Market Risk Premium and reflects investors' degree of risk aversion at a given time.

When used in portfolio management, a single asset is plotted against the SML using its own beta and historical rate of return. If the plot of the asset falls above the SML it is considered to have a good rate of return relative to its risk, and vice versa if it falls below.

The securities market line (SML) graphs the relationship between risk and return. The securities market line is a straight line. It touches the efficient frontier and passes though the risk free rate of return. The SML lies above the efficient frontier, except at the one point where it touches. This shows that the availability of a risk free asset improves the returns available for a any given level of risk and vice-versa.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Capital market line

A graph derived from the Capital Asset Pricing Model that shows the rates of return for efficient portfolios in relation to the level of risk (the market portfolio's beta). The graph forms a positive, linear relationship expressed in the equation,
expected return = risk-free rate + portfolio beta* (the difference between the expected return on the market as a whole and the risk-free rate).

Also known as the CML, it is determined by the intercept point on the efficient frontier and the point at which the expected return is equal to the risk-free rate of return. This measure is considered superior to the efficient frontier because it additionally takes into account the inclusion of a risk-free asset in the portfolio.

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.

The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).