INVESTMENT ANALYSIS – SECURITY MARKET LINE (SML)

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LITTLE THEORY ON THE SECURITY MARKET LINE:

 Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk .

When used in portfolio management, the SML represents the investment's opportunity cost (investing in a combination of the market portfolio and the risk-free asset). All the correctly priced securities are plotted on the SML. The assets above the line are undervalued because for a given amount of risk (beta), they yield a higher return. The assets below the line are overvalued because for a given amount of risk, they yield a lower return.

ILLUSTRATION:

Suppose the expected rate of return on  a security is 25% and if the beta is 1.5, determine whether the security is under priced, fairly priced or overpriced if the risk free rate is 13% and the return on the market portfolio is 20%.

SOLUTION:

SML Equation: E(R) = Rf + (E(Rm) – Rf) β

13% + (20% - 13%) 1.5

13% + (7%) 1.5

13% + (10.5)

Expected Rate:=23.5%

Note: To know that this security is under-priced, fairly priced or overpriced, the rate of return of security will be given and in this case, it is 25%.

Since the rate of return of the security is 25%, our expected rate is 23.5%. That means the security is under-priced.  That is to say, it is good for the investor when it is under-priced.

I will through more light on this tomorrow: