Security Market Line

The Security Market Line (SML) is a visual representation of the Capital Asset Pricing Model (CAPM). It plots expected return against beta (systematic risk) and shows the theoretical fair return for any level of market risk.

SML Components:

• Y-axis: Expected return
• X-axis: Beta (systematic risk)
• Intercept: Risk-free rate (where β = 0)
• Slope: Market risk premium (Rm - Rf)

Reading the SML:

Position	Meaning	Action
Above SML	Undervalued (excess return for risk)	Buy — positive alpha
On SML	Fairly valued (return matches risk)	Hold — zero alpha
Below SML	Overvalued (insufficient return for risk)	Sell — negative alpha

SML vs. CML (Capital Market Line):

Feature	SML	CML
Risk Measure	Beta (systematic only)	Total standard deviation
Applies To	Any security or portfolio	Efficient portfolios only
Purpose	Pricing individual securities	Optimal portfolio construction

Example:

• Risk-free rate: 4%
• Market return: 10%
• Stock A: Beta = 1.3, Actual return = 14% → Above SML (α = +2.2%)
• Stock B: Beta = 0.8, Actual return = 6% → Below SML (α = -2.8%)

Practical Application:

• Fund managers are evaluated by where their portfolios plot relative to the SML
• Positive alpha (above SML) = skilled management
• Negative alpha (below SML) = underperformance

Limitations:

• Based on CAPM assumptions (single factor, efficient markets)
• Beta isn't stable over time
• Real markets have multiple risk factors beyond beta