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Security Market Line and Characteristic Market Line

Security Market Line

The security market line shows the linear relationship between Systematic risk (which is non –diversifiable, and affects the market as a whole) and the expected return of the entire financial market. It signifies the relationship between expected returns and beta, on which both portfolios and individual securities lie.

These are typically depicted when Expected returns and Beta Coefficients are plotted across a graph. The x-axis represents the risk or Beta and y-axis represents the expected returns.

The slope of the security market line helps in determining the market risk premium. So the value of a security can be judged based on where the return from such security is plotted.

Characteristic Line

A characteristic Line is a graph representing the relationship between Security Returns and Market Index returns. It plots the performance of a particular security against that of a market portfolio at every point in time. Characteristic Line is used to estimate Beta and determine how a security’s return correlates to a market index return.

The X axis is the excess return of the market in general and the Y axis is the excess return on a security over the risk free return. The slope of the Characteristic Line represents the security’s Beta and the Intercept represents its apha.

Alpha is the difference between the Investment’s actual expected return and its Fair return (as per CAPM). It is an absolute measure, which is the return on the Portfolio in excess of the CAPM return. It measures the value addition provided by an Asset manager compared to the market index, given a portfolio’s market Risk.

The distinction between Security Market line and Characteristic Line

Source by shineyf

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