What is Security Market Line?
Security Market Line is the representation of capital asset pricing model (CAPM). Under Capital Asset Pricing model, risk of an individual risky security refers to the volatility of the security’s return vis – a – vis the return of the market portfolio. The risk in the individual risky securities is the systematic risk. Systematic risk is the co-variance of an individual risky security with the market portfolio.
Moreover the co-variance of any asset is represented by its variance. So the return on market portfolio should depend on its own risk. This is shown by the variance of the market return (σ²M). Risk and return relationship is represented as below –
E(Rj) = Rf + [E(Rm) – Rf)/σ²M ](Covar j,m)
σ²M (Covar j,m)/ σ²M represents the security beta. Beta is a standardised measure of a security’s systematic risk. The beta market portfolio is equals to 1. Similarly a risk free security has no volatility hence its beta is equals to zero.
Therefore the equation for Security Market Line is as follows –
E(Rj) = Rf + [E(Rm) – Rf]Bj
where, E(Rj) = expected return on security
Rf = risk free rate of interest
Rm = the expected return on market portfolio
Bj = undiversifiable risk of security j
Security Market line with systematic risk is measured by Beta. The risk premium on a risky security is equal to a risk free rate plus the risk premium of the risky security. Risk premium on a risky security equals to the market risk premium. This is the difference between the expected market return and the risk free rate. For a given amount of systematic risk, security market line shows the required rate of return.
Difference between Capital Market Line (CML) and Security Market Line (SML)
|Capital Market Line||Security Market Line|
|It represents the risk premium of efficient portfolios as a function of portfolio standard deviation.||It depicts individual security risk premium as a function of security risk|
|If security return has perfect correlation with return on market portfolio, CML coincides with SML.||All the fairly valued assets|