Security Market Line (SML)
.We know that risk averse investors seek risk premium to assume the risk embedded in risky assets. The risk is variability in return. The total risk consists of two components: systematic risk and unsystematic risk. In a portfolio of risky assets, the investor can eliminate unsystematic risk through diversification, as suggested by Markowitz. Systematic risk is unavoidable; this is the contribution of an individual asset to the risk of market portfolio.
According to the capital market theory, the market compensates or rewards for ; systematic risk only. The level of systematic risk in an asset is measured by the beta coefficient, The CAPM links beta to the level of required return. Graphic depiction of the GAPM-the expected returnable relationship-is referred to as the Security Market Line (SML). This is illustrated SML is a linear relationship defined by Equation 3..25.
E(r) = r, + B (E(r,) - r)
Expected return = Risk-free return + (Beta x Risk premium of market)
on security ; = Intercept + (Beta x Slope of SML)
The more familiar form of the SML