Models of capital asset pricing (CAPM) is a measure that describes the relationship between systematic risk of a security or portfolio and its profitability. Market security line (SML) the CAPM formula is used to display the expected return of a security or portfolio.
The formula of CAPM-risk-free yields added in beta of a security or portfolio multiplied by the expected market return minus the risk-free rate of return. This gives the expected yield of the security. Beta measures a security’s systematic risk and its sensitivity towards changes in the market. Security with a beta of one has a perfect positive correlation with the market. This means that when the market falls or rises, increases security or decreases in time with the market. A security with beta greater than 1 has more systematic risk and volatility than the market and a security With a beta less than 1 is less systematic risk and volatility than the market.
Market security line (SML) is a graphical representation of the CAPM formula. It builds the relationship between expected return and beta or systematic risk associated with security. The expected return of securities is deposited on the Y-axis and beta securities is plotted along the x-axis. The slope of the plotted relationship is called the market risk premium, the difference between the expected return of the market and the risk-free return, and this poses a risk of return of a security or portfolio.
Together, SML and the CAPM formula is useful in determining if a security considered for investment, offers a reasonable expected return for the amount of risk taken on. If expected to return against his beta on the graph above the security market, it is undervalued taking into account risk and return. Conversely, if expected security return against its systematic risk is constructed below the SML, it is overvalued because the investor would receive less income for the amount of systematic risk.
For example, suppose the analyst constructs of SML. Risk-free rate is 1% and the expected market return of 11%. Beta of ABC stock is 2.2, meaning it carries the most volatility and more systematic risk. Expected return of stock ABC is 23%. If the current profitability of ABC stock is 33%, it is undervalued because investors expect a higher yield for the same amount of systematic risk. On the contrary, say that the expected return of stock XYZ is 11% and current yield is 8% and below the SML. The stock is overvalued, investors accept a lower return for a given level of risk, which is a big risk to profitability.