Assignment Topic:

Security Market Line (SML)

Resource person: Prof. Ali Hiader Submitted by: HAFIZ MUHAMMAD IMTIAZ Program: Ms Finance (SBE) ID number: (12003096005)

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Security Market Line (SML)

The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta. The CAPM equation describes a linear relationship between risk and return. Risk, in this case, is measured by beta. We may plot this line in mean the security Market Line (SML) expresses the basic theme of the CAPM i.e., expected return of a security increases linearly with risk, as measured by beta. The SML is an upward sloping straight line with an intercept at the risk free return securities and passes through the market portfolio. The upward slope of the line indicates that greater excepted returns accompany higher levels of beta. In equilibrium, each security or portfolio lies on the SML shows that the return expected from portfolio or investment is a combination of risk free return plus risk premium. An investor will come forward to take risk only if the return on investment also includes risk premium. CAPM provides an intuitive approach for thinking about the return that an investor should require on an investment, given the asses systematic or market risk. Figure

One remarkable fact that comes from the linearity of this equation is that we can obtain the beta

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Of a portfolio of assets by simply multiplying the betas of the assets by their portfolio weights. Easy the line also extends out infinitely to the right, implying that you can Borrow infinite amounts to lever up your portfolio. Why is the line straight? Well, suppose it curved, as the blue line does in the figure below. An investor could borrow at the riskless rate and invest in the market portfolio. Any investment of this type would provide a higher expected return than a security which lies on the curved line below. In other words, the investor could receive a higher expected return for the same level of systematic risk. In fact, if the security on the curve could be sold short, then the investor could take the proceeds from the short sale and enter into the levered market position.

Expectations vs. Realizations

It is important to stress that the vertical dimension in the security market line picture is expected Return. Things rarely turn out the way you expect. However, the CAPM equation also tells us About the realized rate of return. Since the realization is just the expectation plus random error We can write: R i = Rf + i [ Rm - Rf ] + ei This is useful, because it tells us that when we look at past returns, they will typically deviate From the security market line not because the CAPM is wrong, but because random error Will push the returns off the line. Notice that the realized R m does not have to behave as Expected, either. So, even the slope of the security market line will deviate from the average Equity risk premium. Sometimes it will even be negative.

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When a shift in the SML occurs, a change that affects all investments' risk versus return profile has occurred. A shift of the SML can occur with changes in the following: Expected real growth in the economy. Capital market conditions. Expected inflation rate Beta and the Risk Premium A riskless asset has a beta of 0. Beta of portfolio is a weighted average of Betas of individual The line which gives the expected return - systematic risk combinations Given the Market Portfolio has an "average" systematic risk, i.e., it has a beta of 1. Since all assets must lie on the security market line when appropriately priced, so must the market portfolio. Denote the expected return on the market portfolio.

Characteristic Line
A rational investor would not invest in an asset which does not improve the risk-return Characteristics of his existing portfolio. Since a rational investor would hold the market portfolio, The asset in question will be added to the market portfolio. Specific risk is the risk associated with individual assets - within a portfolio these risks can be Reduced through diversification. Systematic risk, or market risk, Refers to the risk common to all securities except for selling short as noted below, systematic Risk cannot be diversified away (within one market). Within the market portfolio, asset specific Risk will be diversified away to the extent possible. Systematic risk is therefore equated with The risk (standard deviation) of the market

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portfolio. Since a security will be purchased only if it improves the risk / return characteristics of the Market portfolio, the risk of a security will be the risk it adds to the market portfolio. In this Context, the volatility of the asset, and its correlation with the market portfolio, is historically Observed and is therefore a given (there are several approaches to asset pricing that attempt to Price assets by modeling the stochastic properties of the moments of assets returns - these are Broadly referred to as conditional asset pricing models). The (maximum) price paid for any Particular asset (and hence the return it will generate) should also be determined based on its Relationship with the market portfolio. Systematic risks within one market can be managed through a strategy of using both long and Short positions within one portfolio, creating a market neutral portfolio.

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