Economics Risk And Return Questions Medium
The Security Market Line (SML) is a graphical representation of the relationship between the expected return and the systematic risk of an investment. It is derived from the Capital Asset Pricing Model (CAPM) and helps investors evaluate the risk and return trade-off of different investments.
The SML plots the expected return of an investment on the y-axis and the beta (systematic risk) of the investment on the x-axis. Beta measures the sensitivity of an investment's returns to the overall market returns. The SML is a straight line that starts from the risk-free rate of return on the y-axis and has a positive slope, representing the risk premium investors require for taking on additional systematic risk.
The equation of the SML is: Expected Return = Risk-Free Rate + (Beta × Market Risk Premium)
The risk-free rate is the return on a risk-free investment, such as a government bond, which is considered to have no systematic risk. The market risk premium is the excess return that investors expect to earn for taking on the average level of systematic risk in the market.
Investments that lie above the SML are considered to have a higher expected return than their level of systematic risk, making them attractive investments. Conversely, investments below the SML are considered to have a lower expected return than their level of systematic risk, making them less desirable.
The SML is a useful tool for investors to assess the risk and return characteristics of different investments and make informed decisions about their portfolio allocation. By comparing an investment's expected return to its systematic risk, investors can determine whether the investment is adequately compensating them for the level of risk they are taking.