What Is the Security Market Line (SML)?
The CAPM formula is much easier to grasp once you can picture it as a graph. That picture is exactly the Security Market Line (SML).
The SML Is the CAPM as a Graph
The Security Market Line (SML) is the straight line that translates the CAPM into a graph.
The horizontal axis is beta (β, systematic risk), and the vertical axis is expected return. The y-intercept of this line is the risk-free rate (Rf), and its slope is the market risk premium (market return − risk-free rate).
In other words, the SML shows at a glance that 'for a given beta, this is the fair return to demand.' Sharpe introduced this concept in 1964.
What Being Above or Below the Line Tells You
If an asset's actual expected return lies above the SML, it means the return expectation is high relative to the risk (beta) taken on, which is interpreted as 'relatively undervalued.'
Conversely, if it lies below the SML, the expected return is low relative to risk, so it is seen as 'relatively overvalued.'
But this is only a relative judgment within the theoretical framework of the CAPM, and does not mean 'buy now and profit.' The position shifts with even a small change in the input estimates.
How the SML Differs from the CML
A concept that is easy to confuse is the Capital Market Line (CML).
The horizontal axis of the SML is beta (systematic risk), and it applies to both individual assets and portfolios.
The horizontal axis of the CML is total risk (standard deviation σ), and it applies only to 'efficient combinations' that mix the risk-free asset and the market portfolio.
In short, the SML deals with 'the fair return of an individual asset,' while the CML deals with 'the risk-return frontier of efficient portfolios.'
Systematic risk is the market-wide risk that cannot be eliminated by diversification, while unsystematic risk is individual risk that can be reduced by diversification. The SML holds that only systematic risk (β) is rewarded.
常见问题
Q. Do I profit if I buy a stock that sits above the SML?
No. The SML is only a theoretical relative position under the CAPM's assumptions. If the estimates of beta or market return change, so does the position, and real markets do not move exactly as theory says. It should not be used as a buy signal for a specific stock.
Q. What does it mean when the slope of the SML gets steeper?
The slope is the market risk premium. A steeper slope means the extra reward demanded for taking on one more unit of risk is larger, which can be interpreted as a phase in which the market prices risk more expensively.
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