Understanding the Security Market Line

Expected Risk and Risk Premium

Read this section on expected risk and risk premium. What is a security market line (SML)? How does the SML affect determining the cost of capital? Pay attention to how to use a stock's beta to estimate a stock's daily growth or decline.

The overall riskiness of an asset is composed of its own individual risk (beta) and its risk in relation to the market as a whole.

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 influencing the outcome exists. More specifically, in 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 central to them in the subject of finance. In the financial realm, two types of risk exist: systematic and unsystematic.

Systemic risk is the risk associated with an entire financial system or market. This type of risk is inherent in all marketable securities and cannot be diversified away. On the other hand, unsystematic risk is a risk to which only specific classes of securities or industries are vulnerable. This type of risk is uncorrelated with broad market returns, and with proper grouping of assets, it can be reduced or even eliminated. Because of this characteristic, investors are not rewarded for taking on unsystematic risk.

Systematic risk can be understood further using the measure of Beta. This number describes the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to—usually the market as expressed in an index.

\( \beta_a = \dfrac{Cov(r_a, r_b)}{Var(r_b)} \),

Beta

Beta is a measure that relates the rate of return of an asset, r_a, with the rate of return of a benchmark, r_b.

Values of Beta can be interpreted using the following information:

Betas less than 0: Asset generally moves in the opposite direction compared to the index.
Betas equal to 0: The asset's movement is uncorrelated with the movement of the benchmark.
Beta between 0 and 1: The asset's movement is generally in the same direction as, but less than, the movement of the benchmark.
Beta equal to 1: The asset's movement is generally in the same direction as, and about the same amount as, the movement of the benchmark.
Beta greater than 1: The asset's movement is generally in the same direction as, but more than, the movement of the benchmark.

Risk Premium

The term 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.

Key Points

In return for undertaking risk, investors expect to be compensated in such as a way as to reasonably reward them.
Systemic risk is the risk associated with an entire financial system or entire market. It cannot be diversified away.
Unsystematic risk is risk to which only specific classes of securities or industries are vulnerable, and with proper grouping of assets it can be reduced or even eliminated.
Beta is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to – usually the market as expressed in an index.
The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk-free interest rate.

Terms

Risk Free Rate – a risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
Treasury Bill – (or T-Bills) mature in one year or less. They do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/understanding-the-security-market-line-82/index.html
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