Understanding the Security Market Line

The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.

The Security Market Line The location of a financial instrument above, below, or on the security market line will affect a company's cost of capital.

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 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 instrument's price goes up, its expected returns go down, and vice versa. A firm raising capital would like to sell these instruments for a high price, and investors want to buy them for a low price.

An instrument plotted below the SML would have a low expected return and a high price. This market situation would be quite attractive from the perspective of a company raising capital; however, such an investment wouldn't make sense for a rational buyer. The rational investor will require either a higher return or a lower price, which will result in a higher cost of capital for the company.

An instrument plotted above the line has a high expected return and a low price. This would not be an attractive market situation for a company looking to raise capital. Such a firm wants to raise as much money as possible, which means getting investors to pay the highest price possible.

An instrument plotted on the SML can be thought of as fairly priced for the expected return. Such an instrument would be a fair investment from an individual's perspective and would lead to a fair cost of capital from a company's perspective.