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A certain amount of risk is inherent in any investment. Risk can be defined, generally, as the potential that a chosen action or activity (including the choice of inaction) will lead to a loss or an undesirable outcome. The notion of risk implies that a choice having an influence on the outcome exists. More specifically to finance, risk can be seen as relating to the probability of uncertain future events. In return for undertaking risk, investors expect to be compensated in such a way as to reasonably reward them. This is a central theme in the subject of finance. In the financial realm, two types of risk exist:
Values of beta can be interpreted using the following information:
| Values of Beta | Description |
|---|---|
| Beta less than 0 | Asset generally moves in the opposite direction as compared to the index. |
| Beta equal to 0 | Movement of the asset is uncorrelated with the movement of the benchmark. |
| Beta between 0 and 1 | Movement of the asset is generally in the same direction as, but less than, the movement of the benchmark. |
| Beta equal to 1 | Movement of the asset is generally in the same direction as, and about the same amount as, the movement of the benchmark. |
| Beta greater than 1 | Movement of the asset is generally in the same direction as, but more than, the movement of the benchmark. |
The term market risk premium refers to the amount by which an asset’s expected rate of return exceeds the risk-free rate. The difference between the return of an asset in question and that of a risk-free asset — for instance, a US Treasury bill — can be interpreted as a measure of the excess return required by an investor on the risky asset. The risk premium, along with the risk-free rate and the asset’s beta, is used as an input in popular asset valuation techniques, such as the Capital Asset Pricing Model.
The security market line, also known as the “characteristic line,” is the graphical representation of the capital asset pricing model. It is a hypothetical construct based on a world of perfect information. In the absence of perfect information, we can more or less assume historical data will give us an accurate expectation of what kind of returns and risk to expect with a particular investment of capital. The security market line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities.
The security market line is defined by the equation:
The y-intercept in the secure market line, or where the vertical axis meets the horizontal axis, is also known as the risk-free rate. The assets that are plotted above the line are said to be undervalued for a given level of risk. Conversely, the assets plotted below the line are said to be overvalued due to the given level of risk.
The slope of the SML is the premium that the market charges for risk.
The idea of a security market line follows from the ideas asserted in the last section, which is that investors are naturally risk-averse, and a premium is expected to offset the volatility of a risky investment. In a perfect world, with perfect information, any capital investment is on the security market line. The idea of a security market line is important for understanding the capital asset pricing model.
The security market line is a graphical representation of the capital asset pricing model that illustrates the idea that investments are priced efficiently based on the expected return and beta value (risk). Companies often turn to capital markets in order to generate funds — using the issuance of either debt or equity. The cost of obtaining funds in such a manner is known as a company’s cost of capital. There is a tradeoff between a security’s price and its expected return. If the price of the instrument goes up, its expected returns go down, and vice versa. A firm that is raising capital would like to sell these instruments for a high price, and investors want to buy them for a low price.
The location of a financial instrument above, below, or on the security market line will lead to consequences for a company’s cost of capital:
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