Security Market Line - Explained
What is a Security Market Line?
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Table of ContentsWhat is a Security Market Line?How Does a Security Market Line Work?Using the Security Market Line
What is a Security Market Line?
The security market line (SML) is a chart that symbolizes the visual or graphical representation of the expected rate of return and the expected risks of different securities traded in the market. SML serves as a visual representation of the capital asset pricing model (CAPM) that displays the systematic or market risks of securities. The security market line has two axis, the x-axis and the y-axis. While the x-axis represents the beta or the risk of the assets, the y-axis represents the expected return of the assets. The security market line (SML) is otherwise called the characteristic line.
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How Does a Security Market Line Work?
Basically, SML is a tool that gives a visual representation of the capital asset pricing model (CAPM). The risks and expected returns of marketable assets or securities are plotted on a chart using SML. To plot marketable securities on a chart using the security market line (SML), the formula below is applicable; Required Return = Risk-Free Rate of Return + Beta (Market Return - Risk-Free Rate of Return) The risk of a security or asset indicates the level of volatility that is expected from the security, both the risk (beta) of an asset and the expected return are plotted on the SML. where security is plotted on an SML however determines the market risk premium that such security or asset will incur.
Using the Security Market Line
The beta of a security is an important metric when using SML or CAPM, this metric indicates the non-diversifiable risk or systematic risk of an asset. When calculating the market average, the beta is also a vital metric. Generally, market investors use the security market line (SML) to evaluate securities in an investment portfolio in order to determine the number of risks and expected a return in the underlying portfolio. SML can also be used for the comparison of similar securities. The position of security on the SML chart determines its risks and returns. For instance, security that appears above the SMAL is undervalued meaning that it has higher returns and lower risks.