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.
Impact of the SML on the Cost of Capital
The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.
Describe the impact of the SML on determining the cost of capital
- The security market line is a hypothetical concept that suggests that investors require compensation in the form of expected returns for the risk the investment exposes them to.
- A capital investment below the security market wouldn't be efficiently priced to the buyer of the investment. A higher return or lower price would be required, both increasing the cost of capital.
- A capital investment above the security market line
wouldn't be efficiently priced for the seller or whomever raises the
capital. A lower return or higher price would be necessary to justify
this cost of capital for the company.
- capital asset pricing model
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.
The Security Market Line: The location of a financial instrument above, below, or on the security market line will lead to consequences for 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 in order 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 trade off between a security's price and its expected return. If the price of the instrument goes up, its expected returns go down, and vice versa. A firm that is 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 lower price, which will both 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 to be fairly priced for the amount of 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.