Defining the Security Market Line
The security market line displays the expected rate of return of a security as a function of systematic, nondiversifiable risk.
Learning Objective

Describe the Security Market Line
Key Points
 The security market line is the theoretical line on which all capital investments lie. Investors want higher expected returns for more risk.
 On a graph, the line has risk on its horizontal axis (independent variable) and expected return on the vertical axis (dependent variable).
 Assuming a linear relationship between risk and return, the assumption is that the yintercept is the return on a riskfree investment (the risk free rate), and the slope is the premium on risk in terms of expected returns.
 Given two investments with the same expected return, investors would always choose less risk. Someone with opposite preferences might better be called a gambler.
Terms

market risk premium
the amount by which expected rate of return of the exchange system exceeds the riskfree interest rate

market risk
the potential for loss due to movements in prices in a system of exchange

line of credit
source of debt extended to a government, business or individual by a bank or other financial institution

diversifiable risk
the potential for loss which can be removed by investing in a variety of assets

security market line
Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, nondiversifiable risk (its beta).

beta
Average sensitivity of a security's price to overall securities market prices.
Full Text
The security market line, also known as the "characteristic line", is the graphical representation of the capital asset pricing model. It is a hypothetical construct based on a world of perfect information. In the absence of perfect information, we can more or less assume historical data will give us an accurate expectation of what kind of returns and risk to expect with a particular investment of capital. The security market line graphs the systematic, nondiversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities. The security market line is defined by the equation:
The equation that defines the security market line.
Look at the equation and remember that old formula of a line: y = mx + b. In this case it looks rearranged, like y = b + mx, but the real question is what do the slope and yintercept actually represent?
The Yintercept of the SML is equal to the riskfree interest rate. Recall that the riskfree interest rate is the theoretical rate of return of an investment with no risk of financial loss. When used in portfolio management, the SML represents the investment's opportunity cost  i.e., investing in a combination of the market portfolio and the riskfree asset. All the correctly priced securities are plotted on the SML. The assets that lie above the line are undervalued because for a given amount of risk, they yield a higher return. The assets below the line are overvalued because for a given amount of risk, they yield a lower return.
The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time. The idea of a security market line follows from the ideas asserted in the last section, which is that investors are naturally risk averse, and a premium is expected to offset the volatility of a risky investment. In a perfect world, with perfect information, any capital investment is on the security market line. The idea of a security market line is important for understanding the capital asset pricing model. Let's look at the line again:
The Security Market Line
This is an example of a security market line graphed. The yintercept of this line is the riskfree rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.
Key Term Reference
 Assets
 Appears in these related concepts: Secured vs. Unsecured Funding, Defining LongLived Assets, and Defining the Marketing Objectives
 Interest
 Appears in these related concepts: Interest Compounded Continuously, Accounting for Interest Earned and Principal at Maturity, and Tax Considerations
 Opportunity cost
 Appears in these related concepts: Defining the Payback Method, The Importance of Motivation, and Defining Comparative Advantage
 asset
 Appears in these related concepts: Goodwill Impairment, Shifts in the Money Demand Curve, and Balance Sheets
 capital
 Appears in these related concepts: Temple Architecture in the Greek Orientalizing Period, Minoan Architecture, and The Acropolis
 expected return
 Appears in these related concepts: Expected Return, Types of Financial Decisions: Investment and Financing, and Arbitrage Pricing Theory
 interest rate
 Appears in these related concepts: Greenspan Era, The Financial Account, and Determinants of investment
 investment
 Appears in these related concepts: Functions of Corporate Finance, The Role of the Financial System, and GDP Equation in Depth (C+I+G+X)
 investor
 Appears in these related concepts: Advantages of Private Financing, Seasoned Equity Offering, and Agency
 portfolio
 Appears in these related concepts: Portfolio Risk, Overview of Warrants, and Contractual Saving
 premium
 Appears in these related concepts: The Term Structure, Redeeming Before Maturity, and Health Insurance
 return
 Appears in these related concepts: Dollar Returns, Comparing the Fields of Finance, Economics, and Accounting, and Disadvantages of the Payback Method
 risk
 Appears in these related concepts: The ExportImport Bank of the United States, Approaches to Assessing Risk, and Risks Involved in Capital Budgeting
 risk premium
 Appears in these related concepts: Understanding Future Stock Value, Measuring and Managing Risk, and The Value of Diversification
 securities
 Appears in these related concepts: Secondary Market Organizations, Types of Market Organizations, and Financial Instruments
 security
 Appears in these related concepts: Advantages of Public Financing, Pricing a Security, and Underwriter
 slope
 Appears in these related concepts: SlopeIntercept Equations, Rates of Change, and Slope
 volatility
 Appears in these related concepts: Misleading Graphs, Historical Returns: Market Variability and Volatility, and BlackScholes Formula
 yield
 Appears in these related concepts: Bonds Payable and Interest Expense, Stock Warrants, and Calculating the Yield of an Annuity
Sources
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