What do we mean by Security Market Line?
The Capital Asset Pricing Model is graphically represented by drawing the Security Market Line. It shows the amount of returns an investor can expect from the market with regard to the different levels of market or systematic risk. These risks are those whose elimination is further not possible by diversification. In other words, it depicts the relationship between the risks of a security, measurable by its beta coefficient, and the returns that one can expect from it at every level of risk.
The concept of the Security Market Line is very popular for portfolio management. It helps to derive the pricing of risky securities by plotting their expected returns. It takes into account the risk that comes along with such investments, as well as the cost of capital. Also, it represents the opportunity cost of an investment and guides an investor to compare an investment opportunity at market risk with a risk-free investment.
- What do we mean by Security Market Line?
- Equation for Security Market Line
- Main Components of the Security Market Line
- Interpretation of the Security Market Line
- Example of a Security Market Line
- Advantages and Disadvantages of the Security Market Line
The other name for Security Market Line is the “characteristic line”. While graphically representing this line, we plot the beta or the asset risk on the x-axis. The plotting of the return an investor expects from a security is done on the y-axis.
Equation for Security Market Line
The Security Market Line basically represents the prevailing risk-free return and the beta coefficient of the security. The formula to calculate the expected return and plotting the Security Market Line is:
SML= Risk-free rate of return + Beta coefficient (Market rate of return – Risk-free rate of return)
Main Components of the Security Market Line
Let us go through the main components of the above equation in detail.
Beta or Beta coefficient is one of the most important components for using the Security Market Line. It is a numerical value and is a measure of how a stock or security will move when the entire market goes up or down. It measures the systematic risk or the non-diversifiable risk of an asset with regard to the market portfolio.
The overall market average of risk is assumed to be beta value 1. A security with a high correlation to the market will have a beta coefficient greater than one. Such securities fall in the category of being highly risky. On the other hand, a security with a beta coefficient of less than one has a low correlation to the market and is less volatile or less risky.
The above discussion is from a risk perspective. However, the universal law is that the higher the risk, the higher can be the return also. Therefore, securities having a beta coefficient of more than 1 or of course highly risky but in times of upward market trend, they are the ones that will fetch you more returns than the market indices. So higher volatility gives an edge in a rising market.
Suppose a security has a beta coefficient of 1.5. It will mean that it is 50% more risky or volatile than the average of the market. However, if the market goes up by 20%, such a security should go up by 1.5 x 20= 30%.
The Risk-free Rate of Return and Systematic Risk
A risk-free rate of return is the return that an investor will get with any security or investment with near-zero risk over a time period. Thus, it is the least an investor will get as a return from his investment. An investor will go for a riskier investment only if he gets a return that is higher than the risk-free rate of return. Or in other words that is the extra premium or return that attracts him to take extra risk.
This rate is just theoretical and does not actually exist as an option for an investor because every investment comes with some amount of risk. The calculation for this rate is simply done by taking the yield of the Treasury bond and adjusting or subtracting the current inflation rate.
Systematic risk is the risk of operating in the market and that is the same and applicable to all the participants of the market. Diversification of investments does not eliminate this risk. Factors that cause such a risk can be economic and policy changes, interest rates, political disturbances, natural calamities, etc.
Expected Market Return
It is the rate of return available in the present scenario for various types of securities under consideration. In this exercise, we have the expected rate of return for all the available securities. This we compare with the risk-free return. And thereafter according to the gap/difference in the returns, the beta calculation, and ranking happens. Then finally based on the risk appetite and portfolio composition the securities for investment purpose is identified.
Time Value of Money
This concept means that an amount of money in hand is more worthy than the same sum of money at some future date. This is so because money has the potential to grow, either by investing it in some business activity, the stock market, or simply by depositing it with a bank and earn interest on it.
Thus, a prudent investor will want returns from his investment because of the risk he undertakes on his investment. His money has an opportunity cost- he can invest it in other avenues other than the current security investment option and still generate returns. Moreover, he will want higher returns on his investment from securities with a high beta because of the higher risk he will bear than the market average.
Interpretation of the Security Market Line
In the field of finance, the Security Market Line has a slope when we present it graphically. An investor looks for extra returns to offset the extra risk he will be taking by investing in a particular security. Hence, the difference between the risk-free return available in the market and the expected return of the investor from such a risky security is named as the market risk premium. This market risk premium guides the slope of the SML. The slope will be steep with a high market risk premium, and gradually it will decrease as the market risk premium goes down. A zero beta security or a security with nil market risk premium has the risk-free rate as its expected rate of return.
The Security Market Line can reflect the correct pricing of an asset. It helps to ascertain whether a security is overpriced or under-priced and thus, is crucial for making prudent investment decisions. An asset will be under-priced or undervalued if it appears above the SML in the graph. It is so because it is giving a higher return than the market at a given level of systematic risk. Similarly, an asset will be overpriced or overvalued if it appears below the SML. The logic is the same- it is giving a return lower than the market at a particular level of systematic risk.
Example of a Security Market Line
Let us assume that the risk-free rate is 4%, and the market returns that an investor should expect is 15%. We have two securities in hand: A with a beta of 0.6 and B with a beta of 1.8.
Now let us calculate the expected market return from both the securities by using the SML equation.
Expected return for Security A: 4 + 0.6 (15-4)
= 4 + 0.6(11)
Expected return for Security B: 4 + 1.8(15-4)
=4 + 1.8(11)
Thus security B has higher expected returns because it has a higher beta and hence, is riskier than security A.
Advantages and Disadvantages of the Security Market Line
The SML like any other indicator has certain advantages and certain disadvantages as well. Let us understand first the advantages it offers:
Advantages of SML:
- The SML model along with the CAPM is very easy to use and easily comprehendible. It plays a major role in portfolio planning and management. It helps an investor or a portfolio manager to make rational investment decisions by charting the expected returns from securities and asset classes.
- The model does not ignore systematic risk or market risk while giving the expected returns. This is important and helpful as such risk comes along with every investment opportunity and cannot be done away with.
Disadvantages of SML:
- The SML and CAPM models use the risk-free rate as their basis for calculations. This rate can change, causing volatility and unpredictability in the results of the model.
- The market returns an investor uses for calculations come from past results that are not certain to be the same in the current times or future. Also, they can be negative in the short term and change over time, causing the results to be unreliable.
- Factors such as inflation or deflation, economic and political changes, or other macroeconomic factors such as unemployment can cause the slope of the SML to change or shift with time. Hence, the results will keep changing and not be constant.
- The basis for calculations in this model is the beta coefficient an investor decides to take for his security. The results from the use of this model will go wrong if the calculation of beta is wrong or it changes with time.