The security Market line is the line that we get when we plot the beta of different Securities and the expected return of different Securities. The security Market line is upward-sloping. The reason is that if you have more systematic risk, which is measured by a beta for security then the investors are going to expect a higher return. So more risk means a higher return. Now, if you have a beta of 1 and that’s the market portfolio, would have a beta of 1 we can just trace that up to our Market security Market line, and then we can trace it over to right here on our y-axis, and that’s going to tell us the expected return for the market portfolio.
So let’s say, for example, that we had a company that had a beta of 1.7 and we’re going to trace that up to the security Market line, and then we’re going to trace that over to the y-axis and that will tell us the expected return for this security. Whatever company this is, let’s just say that it’s some technology company. So it’s some tech stock and as is the beta of 1.7, and then let’s say that it has an expected return of 12%. So that’s all this is telling you here. If you’ve noticed, this is actually a visual representation of the capital asset pricing model or CAPM, which we wrote about in another article.
So if you remember from the capital asset pricing model we’ve got the expected return of the security Ri is equal to the risk-free rate Rf, which we see represented here. So let’s just say it’s 2% or something and then we add to the risk-free rate we add the beta of that security, which we’ve got on our x-axis. We’ve got the different betas for that tech company, for example, It was 1.7, and then we’ve got the market risk premium, which is the expected return on the market portfolio – the risk-free rate. This Market risk premium from the capital asset pricing model. That is the slope of this line. So this is the market risk. Premium is the slope of this line. We’ve got the risk-free rate and so forth.
Why do We Use Security Market Line
If we could think of any company and look at what their beta is, you can trace for any company or any security, look at the beta and you could trace that to security Market line. So the security Market line is very important because it’s telling us the reward that investors expect to receive forbearing different levels of risk. So obviously as the systemic risk for a company cannot be Diversified away. So the higher the systematic risk the higher the expected return. In terms of the beta getting larger and larger than there’s going to be a higher and higher expected return on that security. Remember the higher the beta is there’s going to be a higher, systematic risk, and then investors are going to demand a higher return for bearing that increased amount of risk.