Explain Capital Market Line and Security market line.
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Answer Posted / rehan rao
In Modern Portfolio Theory, the Security Market Line (SML)
is the graphical representation of the Capital Asset Pricing
Model. It displays the expected rate of return for an
overall market as a function of systematic,
non-diversifiable risk (its beta).
The Y-Intercept (beta=0) of the SML is equal to the
risk-free interest rate. The slope of the SML is equal to
the Market Risk Premium and reflects investors' degree of
risk aversion at a given time.
When used in portfolio management, a single asset is plotted
against the SML using its own beta and historical rate of
return. If the plot of the asset falls above the SML it is
considered to have a good rate of return relative to its
risk (the asset is undervalued by the CAPM, and should be
acquired), and vice versa if it falls below (the asset is
overvalued, and should be sold).
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