Security Market Line (SML) 📏💹
While the CML is used for efficient portfolios, the Security Market Line (SML) is the graphical representation of the CAPM that can be used for any investment—whether it is a single stock, a bond, or a massive portfolio.
1. What is the SML?
The SML plots Expected Return (Y-axis) against Systematic Risk (Beta) (X-axis).
- Intercept: Starts at Rf.
- Market Point: Passes through the point (Beta = 1.0, Return = Rm).
- Logic: Every asset in a rational market should lie exactly on this line.
2. Using SML for Stock Picking
This is the most practical part of the theory. If you calculate a stock's expected return (using its future dividends or growth) and plot it against the SML:
- Above the SML: The stock is Undervalued (Underpriced). It is giving more return than it should for its risk level. BUY.
- Below the SML: The stock is Overvalued (Overpriced). it is giving less return than it should for its risk level. SELL.
- On the SML: The stock is Fairly Priced.
3. CML vs. SML (Comparison)
Students often confuse these two lines. Here is the difference:
| Feature | Capital Market Line (CML) | Security Market Line (SML) |
|---|---|---|
| X-Axis | Total Risk (Standard Deviation) | Systematic Risk (Beta) |
| Applicability | Only Efficient Portfolios | Individual Stocks & Portfolios |
| Purpose | Building the best portfolio | Finding over/undervalued stocks |
Important
If a portfolio is efficient, it lies on both the CML and the SML. If an individual stock is diversified, it still only lies on the SML.
Summary
- The SML is the graph of the CAPM equation.
- It uses Beta as the measure of risk.
- Stocks above the SML are called "Alpha-positive" and are attractive to investors.
- It is the standard tool for "Equity Analysis" in the banking world.
Quiz Time! 🎯
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