Nov 04

Security Market Line (SML) – 9 min briefcast

by David Harper, CFA, FRM, CIPM

This compares the capital market line (CML) to the security market line (SML). Key ideas for FRM candidates:

CML plots expected return as function of portfolio volatility; SML plots expected return as function of beta. Both are risk/return but CML is total risk and SML is systematic risk (related: the CML informs the Sharpe ratio, the SML informs Treynor and Jensen’s alpha)
Both are anchored on y-axis at the riskless portfolio; i.e., a riskless asset/portfolio offers neither volatility nor systematic risk. Both contain the market portfolio (recall the market portfolio has the highest Sharpe ratio among the portfolio efficient frontier set). On the SML, the market portfolio is located, by definition, where beta equals 1.0
The SML says an asset/portfolio’s expected excess return (excess return = expected return – riskless rate) is proportional to its systematic risk. So, this is a single-factor model where the single-factor is sensitivity, as measured by beta, to the equity risk premium (ERP). ERP is also called the price of risk; beta is also called the quantity of risk. So, CAPM says: security’s expected excess return = quantity of risk * price of risk.
Beta is covariance (instrument, portfolio)/variance (portfolio). It is also the same as the optimal hedge ratio, as both are slope metrics (see beta is one idea with many faces)

Screencast: