## Understanding the Security Market Line

Read this section that discusses expected risk and risk premium, defining the security market line, and the impact of the SML on the cost of capital.

### Expected Risk and Risk Premium

Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.

#### LEARNING OBJECTIVE

• Use a stock's beta to estimate a stock's daily growth or decline.

#### 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

Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.

• treasury bill

Treasury bills (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.

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 as a way as to reasonably reward them. This is a central 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 entire market. This type of risk is inherent in all marketable securities and cannot be diversified away. On the other hand, unsystematic risk is 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 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 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.

$\beta_{a}=\frac{\operatorname{Cov}\left(r_{a}, r_{b}\right)}{\operatorname{Var}\left(r_{b}\right)}$,

Beta: Beta is a measure that relates the rate of return of an asset, ra, with the rate of return of a benchmark, rb.

Values of Beta can be interpreted using the following information:

• Betas less than 0: Asset generally moves in the opposite direction as compared to the index.
• Betas 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.