The Security Market Line

Let me wish all of you a very happy 2010 to begin with. May you [and me too :)] grow in wisdom this year.

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We have heard about the Capital Asset Pricing Model (CAPM). It is a part of Capital Market theory that deals with risk and expected return. It emanates from Harry Markowitz's Portfolio Theory but has been given a formal shape by William Sharpe (1964), John Lintner (1965) and Jan Mossin (1967).

Since this is supposed to be a short post on the Security Market Line (SML), I am not going to go into the derivation of it. It would suffice to say the when the CAPM (which is basically not much more than a linear regression), is represented graphically, it offers us two lines in the risk - return space. One of those lines is called the Capital Market Line (CML) and the other is the SML.

The CML builds on Markowitz's concept of an efficient portfolio but brings in the variable called the risk - free rate of return. Also, the risk is assessed by the standard deviation of the asset's return (total risk). It therefore examines the risk - return relationship of efficient portfolios.

The SML defines Systematic risk as the only relevant risk (since that is the one that must be tolerated and rewarded for by the market) and therefore rather than standard deviation, it uses the Beta of the asset as a measure of risk. The SML examines the risk - return relationship of all assets and portfolios regardless of efficiency.

You might wonder what is an efficient asset or portfolio. To be efficient, an asset or a portfolio has to satisfy either of the following conditions:

1. It offers you maximum return for a given level of risk 
2. It asks you to tolerate minimum risk for a given level of return

Since CAPM, in order to give us reliable results, must satisfy the requirements of linear regression, I would suggest using it with the awareness of this fact. You may not want to discard it. Rather, use it wisely.

The SML can be used to:

1. Classify securities as defensive (Beta < 1) or aggressive (Beta > 1)
2. Identify undervalued (plotting above the SML) or overvalued (plotting below the SML) securities
3. Classify groups of securities into either low - risk or high - risk classes.

Your further readings on the subject will reveal vigorous support and criticism of the CAPM and the world has begun to move on with, for example, Fama and French's Three - Factor Model, the discussion of which is beyond the scope of this brief and humble post.

The video below explains each component of the CAPM equation and plots the SML for a simple piece of data: