The security market line is an investment evaluation tool derived from the CAPM—a model that describes risk-return relationship for securities—and is based on the assumption that investors need to be compensated for both the time value of money (TVM) and the corresponding level of risk associated with any investment, …
What does the security market line depict?
The security market line is a graphical representation of the capital asset pricing model that illustrates the idea that investments are priced efficiently based on the expected return and beta-value (risk).
What is the relationship between CAPM and SML?
The CAPM is a formula that yields expected return. Beta is an input into the CAPM and measures the volatility of a security relative to the overall market. SML is a graphical depiction of the CAPM and plots risks relative to expected returns.
How do you read a security market line?
The two-dimensional correlation between expected return and beta can be calculated through the CAPM formula and expressed graphically through a security market line, or SML. Any security plotted above the SML is interpreted as undervalued. A security below the line is overvalued.
What determines the slope of the security market line?
Market risk premium determines the slope of the security market line. The slope gets steeper with the increasing value of market risk premium. … Assets lying above the security market line are undervalued because they give greater expected returns at a given value of risk.
Can security market line negative?
This equation describes the Security Market Line (SML). The two curves are equivalent only if (i.e., portfolio i is perfectly correlated with the market portfolio); if , and E(Ri) is equal, the CML has a higher slope with respect to the SML; with , the SML will have a negative slope. …
What is the impact of inflation on security market line?
An increase in the inflation premium will cause an upward shift in the SML. The increase in risk free rate due to increase in inflation has an equal impact on the increase in rate of return on all classes of risk assets i.e. high risk and low risk.
How do I know if CAPM holds?
One test of the CAPM is to test whether the alpha of any security or portfolio is statistically different from zero. The regression would be run with available stock returns data. The null hypothesis is (the CAPM holds) is that the intercept is equal to zero.
What are the basic assumptions of CAPM?
The model assumes that all active and potential shareholders have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption). The model assumes that the probability beliefs of active and potential shareholders match the true distribution of returns.
What is the difference between capital market line and security market line?
One of the differences between CML and SML, is how the risk factors are measured. … Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.
Can SML be downward sloping?
Allowing assets to be in heterogeneous supplies has a similar effect, and may further cause the econometrician to perceive a downward-sloping securities market line, although the actual SML is always upward-sloping.
What is the slope of the security market line quizlet?
The slope of the SML, which is the difference between the expected return on a market portfolio and the risk-free rate. In other words, it is the reward investors expect to earn for holding a portfolio of beta of 1. The equation of the SML showing the relationship between expected return and beta.