Security Market Line

Security Market Line

The Security Market Line (SML) is the graphical representation of CAPM — it plots expected return against beta for all assets in equilibrium.

$E[R_i] = r_f + \beta_i \cdot (E[R_m] - r_f)$

Interpreting the SML

Every fairly priced asset lies exactly on the SML:

• Assets above the SML are underpriced (offer excess return — positive alpha)
• Assets below the SML are overpriced (offer insufficient return — negative alpha)

Excess Return (Jensen's Alpha)

The deviation of an asset's actual return from what CAPM predicts is called its excess return or Jensen's alpha (α):

$\alpha = R_i - E[R_i]^{\text{CAPM}}$

Your Task

Implement:

• sml_return(rf, beta, market_premium) — returns the CAPM expected return: r_f + β × market_premium
• excess_return(actual, expected_capm) — returns the deviation from the SML: actual − expected