The Security Market Line (SML) is a line on a diagram that illustrates the expected return of a security or portfolio of securities at different levels of systematic, or market, risk. It is a crucial concept in the Capital Asset Pricing Model (CAPM), which uses the SML to quantify the relationship between risk and expected return.
The Y-axis on the SML graph represents expected return of a security/portfolio, while the X-axis represents systematic risk (beta). The SML slope is determined by the risk premium in the market.
In the context of CAPM, a security that is correctly priced should plot along the SML. If it plots above, it is considered undervalued (since it gives higher returns for a given risk). If it plots below, it is overvalued (provides lower returns for its risk level).
