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 depend on three things.

• The capital market history shows a reward/premium for risk.

• The real risk (TR) associated with any asset is – systematic (SR) and unsystematic (UR). The pure time value of money is measured by risk – a 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 the beta coefficient can measure it.

• E(R_i ) = R_f + [E(R_M) - R_f ] bi

• [E(R_M) - R_f ] bi is the asset's risk premium, 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 average and excess portfolio returns. 

The zero beta version was developed to examine various approaches based on different values and multiple periods. Research claims the measure appears to be related to the past as a close relationship exists 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 of 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 they are estimated from the historical data used to calculate equity costs for evaluating future cash flow.

• There can be errors when one tries to find future risk rates and expected returns on the market.

bIs are often used to understaff 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.