What does SML mean?

Capital asset pricing model CAPM theory estimates the cost of equity for similar independent firms operating in the same industry. It shows the expected returns for the portfolio asset classes depends on 3 things.

• Based on the capital market history, there is reward / premium for risk.
• The total risk (TR) associated with any asset is – systematic (SR) and unsystematic (UR). The pure time value of money is measured by risk – free rate. Unsystematic can be freely eliminated by diversification and systematic is rewarded.
• The SR associated with an asset is relative to the average and it can be measured by the beta coefficient.
• E(R_i ) = R_f + [E(R_M) - R_f ] bi
• [E(R_M) - R_f ] bi it is the risk premium on the asset which is given by the beta coefficient multiplied by the market risk premium.

The above equation of SML is called CAPM.

Studies have found that portfolios have been designed through linear relationships in the past between the and the avg. excess portfolio returns. To examine various approaches the zero beta version was developed, that was based on different values and multiple time periods. Research claim the measure appears to be related to past as there is a close relationship between the TR and SR.

In a freely competitive market, no security can sell for long at the lowest price that can yield more than the appropriate return on the SML. To improve the realism in such theories, researchers have designed a variety of extensions of such designs.

• It has been found that betas are volatile variables through time and there can be issues when the is estimated from the historical data that is used to calculate costs of equity for evaluating future cash flow.
• There can be errors when one tries to find future risk rate and expected return on the market.

bI's are often used for understaffing the risk and returns in mutual funds. Since the mutual funds are least diversified, they have relative UR and their betas are measured with some precision.