The Security Market Line depicts the CAPM relationship between expected return and beta. It starts at the risk-free rate on the vertical axis and rises with beta at a rate determined by the market risk premium. A stock's beta measures its sensitivity to market movements, and the line summarizes how much return the market typically requires for taking on that level of systematic risk.
Analysts compare an asset's CAPM return (or implied return) to the SML. If the asset's point lies above the line, it offers more return for its risk than the CAPM predicts; if below, it offers less. The SML provides a benchmark for assessing whether risk is being rewarded, and it is often used alongside other valuation tools to gauge relative value.
The SML is part of the CAPM framework and assumes a well-diversified portfolio and a market portfolio serving as the benchmark for systematic risk. It is a theoretical reference; actual asset prices can diverge due to factors like mispricing, taxes, liquidity, or non-systematic risk.
An analyst plots a stock with beta 1.2 and an expected CAPM return of 8%. If the SML value at beta 1.2 is 6%, the stock lies above the line, indicating a higher return for its risk than CAPM would predict.
Capital Asset Pricing Model (CAPM) · Beta · Market Risk Premium · Risk-Free Rate · Efficient Frontier