Security Market Line (SML)

The Security Market Line (SML) is a graphical representation of the relationship between expected return and risk for investments, specifically individual securities. It shows that higher-risk investments should offer higher returns to compensate investors. The line originates from the risk-free rate (like a government bond) and slopes upward, illustrating that as the risk (measured by beta) increases, so does the expected return. The SML helps investors determine whether a security is fairly valued—if it lies above the line, it's undervalued; if below, overvalued. It reflects the idea that returns should correlate with the risk taken.