What is Security Market Line or SML?

Security market line or SML (also known as characteristic line) is the graphical representation of Capital Asset Pricing Model or CAPM. Know more about Capital Asset Pricing Model. Security market line is a straight sloppy line which gives the relationship between expected rate of return and market risk (or systematic risk) of over all market.

The X-axis of the security market line represents the market risk or beta and the Y-axis of SML represents expected market return in percentage at a point of time. Usually the rate of risk free investments is represented as a line parallel to X-axis and it is from here that the SML starts. Fore example if the risk-free ratio is 4%, the beta value of market is 3% and expected return from market is 10%, then expected return will be 4+3(10-4) = 22%; and SML will start from 4% at Y-axis and will pass through 22% when beta is 3.

Security market line is a simple yet powerful tool for finding return and risk associated with a portfolio. Investors can plot individual stock’s beta and expected return against SML. If the expected return from the stock is above SML the stock is considered undervalued and is predicted to offer good return for the risk taken. If the expected return falls below SML, the stock is considered overvalued and is predicted to offer lesser return for the risk taken.

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