Security Market Line
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The Security Market Line (SML) is a key concept in portfolio management used to determine the expected returns of risky securities by accounting for their risk and the cost of capital. The SML is defined by the equation incorporating the risk-free rate and the beta coefficient, which measures systematic risk. While the model aids investors in making informed decisions, its effectiveness can be compromised by volatility in market returns and inaccuracies in beta calculation.
Security Market Line
- 2. 1. Meaning 2. Equation 3. Main Components 4. Advantages 5. Disadvantages 6. Reference Content
- 3. The concept of the Security Market Line is very popular for portfolio management. It helps to derive the pricing of risky securities by plotting their expected returns. It takes into account the risk that comes along with such investments, as well as the cost of capital. The other name for Security Market Line is the “characteristic line”. Meaning
- 4. Security Market Line = Risk-free rate of return + Beta coefficient (Market rate of return – Risk-free rate of return) Equation
- 5. 1. Beta: It is a numerical value and is a measure of how a stock or security will move when the entire market goes up or down. It measures the systematic risk or the non-diversifiable risk of an asset with regard to the market portfolio. 2. The Risk-free Rate of Return and Systematic Risk: A risk-free rate of return is the return that an investor will get with any security or investment with near-zero risk over a time period. Systematic risk is the risk of operating in the market and that is the same and applicable to all the participants of the market. 3. Expected Market Return: It is the rate of return available in the present scenario for various types of securities under consideration. 4. Time Value of Money: This concept means that an amount of money in hand is more worthy than the same sum of money at some future date. Main Components
- 6. • The SML model along with the CAPM is very easy to use and easily comprehendible. • It helps an investor or a portfolio manager to make rational investment decisions by charting the expected returns from securities and asset classes. • The model does not ignore systematic risk or market risk while giving the expected returns. Advantages
- 7. • The SML and CAPM models use the risk-free rate as their basis for calculations. This rate can change, causing volatility and unpredictability in the results of the model. • The market returns an investor uses for calculations come from past results that are not certain to be the same in the current times or future. • The basis for calculations in this model is the beta coefficient an investor decides to take for his security. The results from the use of this model will go wrong if the calculation of beta is wrong or it changes with time. Disadvantages
- 8. Reference To know more about it, click on the link given below: https://efinancemanagement.com/investment-decisions/security-market-line