Security Market Line is a plot of level of systematic and non-diversifiable risk taken versus the expected return of the market at a given time for all the risky assets.
Mathematically,
Rp = Rf + β(Rm – Rf)
Where,
Rp =Required Return
Rf = Risk free rate
β = Systematic Risk (Beta)
Rm =Market Return
Rm – Rf = Market Risk Premium = This is the amount by which expected rate of return exceeds the risk-free rate of return.
β(Rm – Rf) = Risk Premium
Any stock (x, y, z) that has expected rates of return with a plot which is above the SML is under-priced as here the expectation is to receive a return on the stock which is above its required rate of return for a given systematic risk(β). Any stock (P, Q, R) which has expected rates of return with a plot which is below the SML is over-priced as here the expected rate of return is below its required rate of return for a given beta. The reasons for x, y, z are under-priced as compared to P, Q, R is that although x, y, z have same risk as that of P, Q, R respectively, x, y, z gives higher returns.
Example:
Suppose beta of a stock is 1.3, risk free rate of return is 5% and expected return on the market is 12%. Find the expected return for the stock.
Rp = Rf + β (Rm – Rf)
= 5% + 1.3 (12% -5%) = 14.1%
Capital Market Line (CML) Vs Security Market Line (SML)
- CML tells about the risk or return of portfolio whereas SML tells the risk or return of individual stocks
- CML graphs defines efficient portfolios whereas SML graph defines efficient as well as non-efficient portfolios.
- CML uses Standard deviation to measure risk and SML uses beta to measure risk.