This movie/ video describes the Security Market Line (SML) and the Capital Asset Pricing Model (CAPM). Please refer to “Diversification and Efficient Frontier”, “Capital Market Line”, “Systematic and Non-Systematic Risks

” for the basics. Once you know how to evaluate the CAPM, you can also use this to evaluate the “Costs of Working Capitals”. The following is a part of the transcript.

When we derived the Capital Market Line (CML), we showed that it contains the best performed portfolio in terms of risk-return trade-off. This portfolio has 2 major components, a risk-free asset and a “market portfolio”. Moreover, investors are rewarded for higher expected return if they bear higher systematic risk (but NOT for bearing non-systematic risk).

Based on these, we can evaluate the price of an equity by setting the following requirement:

The addition of the new equity has to give better or at least the same additional return/risk ratio of holding additional market portfolio

There are plenty of websites describing how to derive the equation from this requirement. I am not going to repeat here because I think most people are not interested in digging into the math and it is not required in the CFA Level 1 exam anyway. If you want, you can use the google box above to search.

However, I want to provide an insight and help you memorize the equation of Security Market Line (SML). Let’s review the CML,

E (total) = E (risk-free) +s (total) *(E (risky) – E(risk-free)) / s_risky

This can be re-written as,

E (total) = E (risk-free) +s (total) *(E (market) – E(risk-free)) / s_market

because the “risky” asset we used in CML is just the market portfolio.

Now, we know that we are only rewarded for bearing systematic risk. Therefore, the expected return of an equity should only depends on its systematic risk but NOT the non-systematic risk. On the other hand, the market portfolio only contains systematic risk, therefore, we can find the systematic risk of the equity by taking their common part. To take the common part, we just have to take

s_{equity, systematic} = r s_{equity, total}

where r is the co-relation between the equity and the market portfolio. So we just have to substitute s (total) by this equity,

E (total) = E (risk-free) +  r s_{equity, total} *(E (market) – E(risk-free)) / s_market

E (total) = E (risk-free) + covariance (equity, market) *(E (market) - E(risk-free)) / s_market²

E (total) = E (risk-free) + b *(E (market) – E(risk-free))

And this is the security market line (SML).

So, here are some distinctions between the CML and SML:

1)      CML is about the optimal portfolio you can get in the market and SML is for you to evaluate the required return of a security

2)      X-axis of CML is the standard deviation of the risk-asset + market portfolio while that of SML is the covariance of the security and the market (which is systematic risk)

So, if a stock’s expected return is above, on, below the SML, it is said to be under priced, correctly priced and over priced respectively. Actions to be taken are buying, ignore and selling respectively.