The security market line (SML) is a visual depiction of the capital asset pricing version or CAPM. It mirrors the relationship between the supposed return the a security and also its danger measured by its beta coefficient. In various other words, the SML displays the intended return for any type of given beta or reflects the risk associated with any kind of given intended return.
You are watching: What is the slope of the security market line
As was mentioned above, the security market line is based on the adhering to CAPM equation
E(Ri) = RF + βi × (E(RM) - RF)
where E(Ri) is an intended return of a security, RF is a risk-free rate, βi is a security’s beta coefficient, and also E(RM) is one expected market return.
The x-axis that the SML graph is represented by the beta, and the y-axis is stood for by the supposed return. The value of the risk-free price is the beginning of the line.
The change of SML can likewise occur when key economical fundamental factors change, such as a change in the meant inflation rate, GDP, or joblessness rate.
Let’s i think the present risk-free price is 4.75%, and also the expected industry return is 15.50%. Thus, the SML equation will be as follows:
E(Ri) = 4.75 + βi × (15.50 - 4.75) = 4.75 + 10.75 × βi
Suppose that security A has a beta the 0.6, and also Security B has a beta of 1.2. The supposed return of defense A is 11.20%, and the supposed return of security B is 17.65%.
E(RA) = 4.75 + 10.75 × 0.6 = 11.20%
E(RB) = 4.75 + 10.75 × 1.2 = 17.65%
So, reduced risk (lower beta) way lower intended return and also vice versa.
Limitations of use
The security industry line has the same restrictions as CAMP since it is based on the same assumptions. Genuine markets conditions can’t be characterized by solid efficiency since market participants have various abilities to loan or loaned money at a risk-free rate, and transaction expenses are different. Thus, in the real world, the place of a offered stock have the right to be over or below the SML as presented in the number below.
See more: What Is The Greatest Common Factor Of 25 And 40 Gcf(25,40), Gcf Of 25 And 40
So, the graph displayed on actual worths of betas, and expected return of share look prefer a set of points rather than a single line. Stocks above the line space undervalued due to the fact that investors need a greater return for a offered risk (beta) than the CAPM assessment. If stocks are below the security market line, they room overvalued, which method investors call for a reduced return because that a provided risk 보다 was assessed through the CAPM.