SML: Security Market Line, Super Simplified
The security market line is CAPM drawn as a graph. Beta sits on the horizontal axis and required return on the vertical axis. Every fairly priced stock should sit on the line, so a stock above or below it looks mispriced.
What you will learn
- How the SML turns the CAPM formula into a straight-line graph
- Why the intercept is the risk-free rate and the slope is the market risk premium
- How to tell if a stock plots above or below the SML
- What being above the line says about undervalued vs. overvalued
- How the SML differs from the capital market line (CML)
The formulas
- R_f
- risk-free rate (the line's intercept)
- β
- beta (the horizontal axis)
- R_m − R_f
- market risk premium (the line's slope)
- α
- positive means above the line (looks undervalued), negative means below (looks overvalued)
Worked example
Risk-free rate 3%, market risk premium 6%. A stock has beta 1.5 and analysts expect it to return 14%. Is it above or below the SML?
- Required return on the SML = 3% + 1.5 × 6% = 12%
- Compare with the expected return: 14% vs. 12%
- Alpha = 14% − 12% = +2%
- The stock plots above the line, so it offers more return than its risk requires
Answer: The stock sits 2 percentage points above the SML, so it looks undervalued.
Common questions
What is the security market line?
The security market line is a graph of CAPM. It shows the return investors should require for each level of beta. It starts at the risk-free rate when beta is zero and rises in a straight line with a slope equal to the market risk premium.
What does it mean if a stock is above the SML?
A stock above the SML is expected to earn more than CAPM says it should for its beta. That suggests it is undervalued. As investors buy it, its price should rise and its expected return should fall back toward the line.
What is the difference between SML and CML?
The SML plots required return against beta and applies to any single asset or portfolio. The CML plots return against total risk (standard deviation) and applies only to efficient portfolios that mix the risk-free asset with the market portfolio.
What is the slope of the security market line?
The slope is the market risk premium, R_m − R_f. It tells you how much extra required return is added for each one-unit increase in beta. A steeper line means investors are demanding more pay for bearing market risk.