The Security Market Line

The line that results when we plot expected returns and beta coefficients is obviously of some importance, so it's time we gave it a name. This line, which we use to describe the relationship between systematic risk and expected return in financial markets, is usually called the security market line (SML). After NPV, the SML is arguably the most important concept in modern finance.

Market Portfolios It will be very useful to know the equation of the SML. There are many different ways we could write it, but one way is particularly common. Suppose we consider a portfolio made up of all of the assets in the market. Such a portfolio is called a market portfolio, and we will express the expected return on this market portfolio as E(Rm).

Because all the assets in the market must plot on the SML, so must a market portfolio made up of those assets. To determine where it plots on the SML, we need to know the beta of the market portfolio, pM. Because this portfolio is representative of all of the assets in the market, it must have average systematic risk. In other words, it has a beta of 1. We could therefore express the slope of the SML as:

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