Understanding the Security Market Line

Expected Risk and Risk Premium

Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.

A certain amount of risk is inherent in any investment. Risk can be defined, generally, as the potential that a chosen action or activity (including the choice of inaction) will lead to a loss or an undesirable outcome. The notion of risk implies that a choice having an influence on the outcome exists. More specifically to finance, risk can be seen as relating to the probability of uncertain future events. In return for undertaking risk, investors expect to be compensated in such as a way as to reasonably reward them. This is a central them in the subject of finance. In the financial realm, two types of risk exist: systematic and unsystematic.

Systemic risk is the risk associated with an entire financial system or entire market. This type of risk is inherent in all marketable securities and cannot be diversified away. On the other hand, unsystematic risk is risk to which only specific classes of securities or industries are vulnerable. This type of risk is uncorrelated with broad market returns, and with proper grouping of assets can be reduced or even eliminated. Because of this characteristic, investors are not rewarded for taking on unsystematic risk.

Systematic risk can be understood further using the measure of Beta. This is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to -- usually the market as expressed in an index.

Values of Beta can be interpreted using the following information:

• Betas less than 0: Asset generally moves in the opposite direction as compared to the index.
• Betas equal to 0: Movement of the asset is uncorrelated with the movement of the benchmark.
• Beta between 0 and 1: Movement of the asset is generally in the same direction as, but less than the movement of the benchmark.
• Beta equal to 1: Movement of the asset is generally in the same direction as, and about the same amount as, the movement of the benchmark.
• Beta greater than 1: Movement of the asset is generally in the same direction as, but more than, the movement of the benchmark.

Risk Premium

The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate. The difference between the return of an asset in question and that of a risk-free asset -- for instance, a US Treasury bill -- can be interpreted as a measure of the excess return required by an investor on the risky asset. The risk premium, along with the risk-free rate and the asset's Beta, is used as an input in popular asset valuation techniques, such as the Capital Asset Pricing Model.

Defining the Security Market Line

The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.

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, non-diversifiable 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 Y-intercept of the SML is equal to the risk-free interest rate. Recall that the risk-free 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 risk-free 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:

Impact of the SML on the Cost of Capital

The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.

The security market line is a graphical representation of the capital asset pricing model that illustrates the idea that investments are priced efficiently based on the expected return and beta-value (risk). Companies often turn to capital markets in order to generate funds -- using the issuance of either debt or equity. The cost of obtaining funds in such a manner is known as a company's cost of capital. There is a tradeoff between a security's price and its expected return. If the price of the instrument goes up, its expected returns go down, and vice versa. A firm that is raising capital would like to sell these instruments for a high price, and investors want to buy them for a low price.

An instrument plotted below the SML would have a low expected return and a high price. This market situation would be quite attractive from the perspective of a company raising capital; however, such an investment wouldn't make sense for a rational buyer. The rational investor will require either a higher return or lower price, which will both result in a higher cost of capital for the company.

An instrument plotted above the line has a high expected return and a low price. This would not be an attractive market situation for a company looking to raise capital. Such a firm wants to raise as much money as possible, which means getting investors to pay the highest price possible.

An instrument plotted on the SML can be thought of to be fairly priced for the amount of expected return. Such an instrument would be a fair investment from an individual's perspective, and would lead to a fair cost of capital from a company's perspective.