Security Market Line - SML

Security Market Line - SML

The line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.

Notes:

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The X-axis represents the risk (beta), and the Y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

It is a useful tool in determining if 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 since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

See also: Beta, Capital Asset Pricing Model - CAPM, Capital Market Line, Efficient Frontier, Modern Portfolio Theory, Systematic Risk