Security Market Line Flashcards
What is the SML?
Line that reflects the relationship between systemic risk and return available for all risky assets in the capital market at any given time as calculated by CAPM.
It helps investors pick investments that are consistent with their risk preferences and the line shows the required rate of return for a given level of risk.
Explains what happens when a movement, change in slope and shift in SML?
- Movements along the line:
- Demonstrates a change in the risk characteristics for a specific investment such as a change in the systemic risk, liquidity risk or financial risk. A firm might increase leverage or cash flow generation might fall. The security moves up the SML to reflect the higher risk and higher return that is required by investors. This change only impacts the individual investment.
- Change in slope of the SML:
- Change in slope occurs in response to new attitudes of investors toward risk i.e. risk aversion.
- Investors now require a higher rate of return for the same level of risk.
- This is also know as market risk premium and this will affect all investments.
- Market risk premium is not constant suggesting that the SML will change over time. This might be due to yield changes in other assets such as credit risk.
- Shift in the SML
- A shift in the SML reflects a change in expected real growth, inflation, or the each of tightness of money.
- This causes a change in the risk free rate.
- A shift in the SML will affect all risky investments.
Explain the SML Chart?
On the Y Axis you have beta
Intercept is the risk free rate
For a given beta and expected return you can plot each company on the line
If the company is above, i.e. the return for that given beta is higher than the SML would predict, the company is undervalued.
If the company is below the line, then it is overvalued.
What are the drawbacks of the SML?
- Security betas are unstable
- Risk free rate specification problem
- There are other priced risk factors
