What does the security market line depict? This question will likely cross your mind if you’re trading security.
The security market is one of the components of a broader financial market. And it refers to a market where securities are sold and bought between subjects of the economy based on demand and supply.
There are many terminologies to master when trading security or even stocks. Keep reading to learn more about the security market line (SML).
The security market line (SML) depicts the capital asset pricing model’s graphical representation. It shows the relationship between the expected outcomes of a specific investment to the risk involved.
Idiosyncratic risk isn’t part of the SML. What SML does is plot a marketable security’s expected market outcome against the level of market risk.
When calculating SML, note that you have to determine the level of risk by the security’s beta against the market.
The security market is dynamic, and one must understand how the market operates to trade successfully. But how are securities traded?
In practice, people don’t trade securities directly. Instead, they utilize proxies. Examples are the NASDAQ 100, S&P 500 Index, and the Dow Jones Industrial Average (DJIA).
A Handy Tip: Understanding the workings and use of the security market line when trading securities is necessary. However, note that SML isn’t always applicable in practice. Why? Broader assumptions are involved, and they might differ from the real deal.
In other words, SML doesn’t always apply to real-life situations or trades.
Understanding the SML characteristics is essential when trading security.
So, here are essential traits that set the SML apart:
The SML slope gives a clear representation of the market risk premium. The market risk premium is crucial as it compensates for the additional systematic risk related to the security.
What does this imply? It means that if the risk is higher, the security’s market risk premium would be higher; likewise, the security expected overall return.
So the SML slope is the reward-to-risk ratio and equals the difference between your expected market return and the risk-free rate (rf) / divided by the market’s beta.
The beta of the market is constant (1.0). Thus, you can re-write the slope as the market return net of the risk-free rate.
A Handy Tip: The importance of the risk premium is to compensate the investors for situations such as incremental systemic risk one has to undertake as part of the investment in the security.
However, the risk/return profile will remain constant if the market price security is accurate. The position would also be on top of the security market line.
The SML is a visual display of the capital asset pricing mode. However, the capital asset pricing model (CAPM) is a one-factor model. In addition, it’s centered on the level of systematic risk the security is exposed to.
Now, here’s something you must understand when trading security. If the level of systemic risk is larger, you can expect a larger return for your security. Simply put, the higher the risk, the greater the reward if the investment eventually turns out to be favorable.
One thing you also must recognize about the risk and reward relationship is that it is linear. The relationship also explains why the SML is a straight line.
Being a one-factor model implies that it might only apply to some practices. In other words, It might not be upheld in certain practices.
The SML can only be upheld when we have various assumptions like the ones we’ll be diving into shortly. Check them out below.
Here are the limitations the SML has.
Firstly, here is a quick way to interpret the SML slope:
Now, here’s how the market works. If the systemic risk level in security is high, investors usually demand higher returns for the high-risk level.
So, if the security is positioned above the SML, it represents lower risk and higher returns for investors.
On the other hand, if the security is positioned below the SML, then this represents higher risk and lower returns.
Here’s another explanation to shed more light and help make the security market line interpretation a breeze.
From the previous explanation, we said that it is undervalued if the security is plotted above the security market line. But that’s not the focal point here.
The main question is, what is the reason for this specific interpretation?
The reason is this. If the security eventually rises above the security market line (SML), then the security will give the investors higher returns for a specific level of risk.
What does this then imply? It means that the market is yet to exploit the opportunity.
Furthermore, what does it mean when security drops below the security market line? It means the security was overvalued.
The outcome when the security is overvalued is that the returns would be lower than the market for a specific risk level. Furthermore, security like this is overbought.
What does the security market line depict? The SML shows the relationship between the returns one expects from an investment (security) and the risk associated with the investment.
The SML plots an expected return from marketable security at a risk level, which the security’s beta determines against the market.
In practice, some individuals or investors don’t trade securities directly. What they do instead is use a proxy. Examples of the proxies include NASDAQ 100, S&P 500 Index, and the Dow Jones Industrial Average (DJIA).