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Strategic Financial Management · Asset Pricing Theories

Capital Market Line and Security Market Line Explained

Updated 11 October 2026 · Fact-checked

The Capital Market Line (CML) plots expected return against total risk (standard deviation) for efficient portfolios. The Security Market Line (SML) plots expected return against beta for any security. To judge a share, compute its CAPM required return from the SML and compare it with its expected return: higher means undervalued, lower means overvalued.

Understand Capital Market Line and Security Market Line

Start with a simple idea. You can invest in a risk-free asset, such as a Treasury bill, or in risky assets. Combining the two lets you choose any level of risk you like. The Capital Market Line is the line that results when the risk-free asset is combined with the market portfolio.

The CML has expected return on the vertical axis and standard deviation (total risk) on the horizontal axis. It starts at the risk-free rate (zero risk) and passes through the market portfolio M. Its slope is the extra return per unit of total risk, called the market price of risk. Only efficient portfolios, those fully diversified and mixed with the risk-free asset, lie on the CML. Individual shares usually lie below it.

The Security Market Line has expected return on the vertical axis and beta (systematic risk) on the horizontal axis. It starts at the risk-free rate (beta = 0) and passes through the market (beta = 1). Its equation is the CAPM. Every correctly priced security, and every portfolio, lies on it.

To test a share, find its required return from the SML using its beta. Compare it with the return you expect from the share. If expected return is above the SML, the share offers more than its risk demands, so it is undervalued (underpriced). If it is below, the share is overvalued. The gap is the alpha.

Remember the core difference: CML is about total risk and efficient portfolios only. SML is about systematic risk and works for any asset.

Key rules to remember

Capital Market Line
E(Rp) = Rf + [(E(Rm) − Rf) ÷ σm] × σp
σp is the standard deviation of the efficient portfolio; σm is the market's standard deviation.
Slope of CML
(E(Rm) − Rf) ÷ σm
Market price of risk per unit of total risk.
Security Market Line (CAPM)
E(Ri) = Rf + βi × (E(Rm) − Rf)
Gives the required return for a security with beta βi.
Market risk premium
E(Rm) − Rf
This is the slope of the SML.
Alpha / valuation test
α = Expected return − Required return (from SML)
α > 0: undervalued (buy). α < 0: overvalued (sell). α = 0: fairly priced.
Beta
βi = Cov(Ri, Rm) ÷ σm² = ρim × σi ÷ σm
Measures systematic risk.

How to solve Capital Market Line and Security Market Line questions

Use this method for any CML or SML question.

  1. 1Read the question and decide the axis: total risk (σ) means CML; beta means SML.
  2. 2List the given data: Rf, E(Rm), σm, β or σ of the security or portfolio.
  3. 3For CML questions, compute the slope (E(Rm) − Rf) ÷ σm and then the portfolio return Rf + slope × σp.
  4. 4For SML questions, compute the required return Rf + β × (E(Rm) − Rf).
  5. 5If a valuation is asked, compare expected return with required return. Above means undervalued; below means overvalued.
  6. 6If price is asked, discount expected future cash flows (price plus dividend) at the required return to get the intrinsic value and compare it with the market price.
  7. 7State a clear recommendation: buy, sell or hold.

Quickest way: Required return versus expected return

When to use it: Use it for MCQs and short numerical parts that ask whether a share is over- or undervalued.

  1. Calculate the required return: Rf + β × market premium.
  2. Subtract it from the expected return.
  3. Positive difference: undervalued. Negative: overvalued. Zero: fairly valued.
  4. For CML, if the portfolio's risk is given as a multiple of the market risk, the premium scales in the same proportion.

Common mistakes in Capital Market Line and Security Market Line

  • Using beta on the CML or standard deviation on the SML.

    Both lines look alike and both start at the risk-free rate.

    Fix: Remember: CML uses σ (total risk); SML uses β (systematic risk).

  • Using the market return instead of the market risk premium when multiplying by beta.

    Students rush and write Rf + β × Rm.

    Fix: Always compute Rm − Rf first, then multiply by beta.

  • Calling a share undervalued when its expected return is below the required return.

    Confusing a high price with a high return.

    Fix: Higher expected return than required means the price is too low, so undervalued.

  • Plotting an individual share on the CML and judging it.

    Forgetting that the CML applies only to efficient portfolios.

    Fix: Judge individual securities with the SML only.

  • Mixing percentages and decimals, such as 0.12 with 12.

    Switching formats mid-calculation.

    Fix: Convert everything to percentages or decimals at the start and stay consistent.

Worked examples

Example 1

Risk-free rate is 6%, expected market return is 14% and market standard deviation is 16%. An efficient portfolio has a standard deviation of 24%. Find its expected return using the CML.

Show the solution
  1. Slope of CML = (14 − 6) ÷ 16 = 0.5.
  2. Expected return = Rf + slope × σp = 6 + 0.5 × 24.
  3. = 6 + 12 = 18%.

Answer: The expected return of the efficient portfolio is 18%.

Example 2

Rf = 7%, expected market return = 15%. Shares of Kaveri Ltd have beta 1.25 and are expected to give 16% return. Shares of Sundaram Ltd have beta 0.8 and are expected to give 12% return. Judge each share.

Show the solution
  1. Market premium = 15 − 7 = 8%.
  2. Kaveri required return = 7 + 1.25 × 8 = 7 + 10 = 17%.
  3. Kaveri expected 16% < required 17%, so alpha = −1%: overvalued.
  4. Sundaram required return = 7 + 0.8 × 8 = 7 + 6.4 = 13.4%.
  5. Sundaram expected 12% < required 13.4%, so alpha = −1.4%: overvalued.

Answer: Both shares lie below the SML and are overvalued. Kaveri has an alpha of −1% and Sundaram has an alpha of −1.4%. Avoid buying, and consider selling if you hold them.

Exam tips

  • Write the axis of each line (σ for CML, β for SML) in the first line of any theory answer. It earns easy marks.
  • In a difference question, give three points: risk measure, assets covered, and the equation behind each line.
  • In numericals, show the required return calculation separately and then state the buy or sell recommendation.
  • A case-scenario MCQ may give several shares and ask which is most undervalued. Compute alpha for each and pick the largest positive one.
  • A quick sketch of both lines with the risk-free rate intercept and the market point M helps in descriptive answers.

Practice questions from Asset Pricing Theories

Capital Market Line and Security Market Line in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Market Line and Security Market Line: frequently asked questions

What is the main difference between CML and SML?

The CML plots return against total risk (standard deviation) and covers only efficient portfolios. The SML plots return against beta and covers all securities and portfolios. The CML shows the best risk-return trade-off. The SML shows the required return for systematic risk.

How do I know if a share is overvalued using the SML?

Calculate its required return using Rf + β × (Rm − Rf). If the return you expect from the share is lower than this, the share plots below the SML and is overvalued. If it is higher, it is undervalued.

Why does the CML start at the risk-free rate?

A risk-free asset has zero standard deviation, so it sits on the vertical axis at the risk-free return. The line then runs through the market portfolio. Points between them mean lending, and points beyond the market mean borrowing to invest more.

Can an individual share lie on the CML?

Usually not. An individual share carries diversifiable risk, so its total risk is high for its return, and it plots below the CML. Only fully diversified efficient portfolios lie on it.