## What is Security Market Line?

The **Security Market Line (SML)** is a graphical representation of the capital asset pricing model (CAPM), which reflects the linear relationship between a security’s expected return and beta, i.e. its systematic risk.

Table of Contents

- How Does the Security Market Line (SML) Work?
- Security Market Line Formula (SML)
- Security Market Line Graph Example (SML)
- What is the Slope of the Security Market Line?
- How to Interpret the Slope of SML Graph?
- How to Analyze the Efficient Frontier and Market Equilibrium
- Security Market Line (SML) vs. Capital Market Line (CML): What is the Difference?

## How Does the Security Market Line (SML) Work?

In corporate finance, the security market line (SML) visually illustrates the capital asset pricing model (CAPM), one of the fundamental methodologies taught in academia and used in practice to determine the relationship between the expected return on a security given the coinciding market risk.

While the chance of encountering the security market line on the job is practically zero, the capital asset pricing model (CAPM) — from which the SML is derived — is commonly utilized by practitioners to estimate the cost of equity (ke).

The cost of equity (ke) represents the minimum required rate of return expected to be received by common shareholders given the risk profile of the underlying security.

The required rate of return, or “discount rate”, is one of the primary determinants that guide the decision-making process of an investor on whether to invest in the security.

## Security Market Line Formula (SML)

There are three components to the CAPM formula, which are the risk-free rate (rf), the beta (β) and the equity risk premium (ERP).

**Risk Free Rate (rf)**→ The yield received on risk-free securities, which is most often the 10-year treasury bond issued by the government for companies based in the U.S.**Beta (β)**→ The non-diversifiable risk resulting from market volatility (i.e. the systematic risk) of a security relative to the broader market (S&P 500).**Equity Risk Premium (ERP)**→ The difference between the expected market return (S&P 500) and the risk-free rate, i.e. the excess return received from investing in public equities over the risk-free rate.

The CAPM equation starts with the risk-free rate (rf), which is subsequently added to the product of the security’s beta and the equity risk premium (ERP) in order to calculate the implied expected return on the investment.

**Expected Return, E(Ri) =**Risk Free Rate

**+**β (Market Return

**–**Risk Free Rate)

The equity risk premium (ERP) is often used interchangeably with the term “market risk premium” and is calculated by subtracting the risk free rate (rf) from the market return.

**Equity Risk Premium (ERP) =**Market Return

**–**Risk Free Rate