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What is Security Market Line (SML)?

Security Market Line:
It is a graphical representation of Capital Asset Pricing Model (CAPM). The beta shows in X axis. The expected return and risk free rate is shown in Y axis. It helps to determine the risk premium which is a difference of market return and risk free rate. It is a risk and return trade-off where systematic risk are plotted against an individual security in a graph at a given point of time. It helps to determine whether the security is overvalued or undervalued. And also the expected return against systematic risk which cannot be diversified. If the expected return is above the security market line then it is under priced and if it is below the security market line then it is overpriced.

Formula:
E (Ri) = Rf + βi [E(Rm) – Rf]

Where,
E(Ri) = Expected rate of return of security i
Rf = Risk free rate of return
βi = Beta coefficient of security i
E (Rm) = Expected market rate of return

Advantages of Security Market Line:
·         It helps to determine the stock is overvalued or undervalued.
·         It helps to determine the risk and return relationship of a security.

Disadvantages of Security Market Line:
·         It is based on CAPM model which considers market risk only.

Importance:
·         It uses to evaluate the securities against systematic risk.
·         It helps to compare the securities return to opt the best one.

Example: The market rate of return is 12% and the risk free rate is 2.0%. The beta coefficient is 0.5. Find out the expected return of stock A.

Solution: E (Ri) = Rf + βi [E (Rm) – Rf]
= 2 + 0.5 [12 – 2]
= 2 + 5
= 7%

Example: Find out the Expected return of following securities and find out which security is under priced and overpriced:

Stock
Beta coefficient
Market return
Risk free rate
A
0.3
10
2%
B
2.12
8
3%
C
0.50
12
2.5%

Solution: E (Ri) = Rf + βi [E (Rm) – Rf]
Stock A:
= 2 + 0.3 [10 – 2]
= 2 + 2.4
= 4.4%


Stock B:
= 3 + 2.12 [8 – 3]
= 3 + 10.6
= 13.6%

Stock C:
= 2.5 + 0.5 [12 -2.5]
= 2.5 + 14.25
= 7.25% 

Example: Suppose stock A and B has same level of risk. Mr. Verma wants to invest in any one of the stock. But it is difficult for him to decide which stock is best because both the stock have same market risk. The information of both the stocks is as follow:

Stock
Market return
Risk free rate
A
12
4
B
11
4
Beta coefficient of both the stock is 2.
Find out the expected return of both the securities?

Solution:
With the help of Security Market Line (SML) we can find out the expected return of each security and also we can compare the securities to ascertain the best one by evaluating the return.
E (Ri) = Rf + βi [E (Rm) – Rf]

Stock A:
= 4 + 2 [12 – 4]
= 4 + 16
= 20%
Stock B:
= 4 + 2 [11 -4]
= 4 + 14
=18%
  


Comments

  1. Phani KumarJune 21, 2020 4:06 pm


    Hey, thanks for the information. your posts are informative and useful. I am regularly following your posts.
    The Hindprakash IPO



    ReplyDelete
  2. JenniferJune 26, 2020 2:33 pm

    Discount bonds are those bonds that have been sold by a customer at a price below the face value of the same.
    Different Types of Bonds

    ReplyDelete
  3. Phani KumarJuly 06, 2020 3:58 pm

    Hey, thanks for the information. your posts are informative and useful. I am regularly following your posts.
    AB Infra build IPO

    ReplyDelete

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