Above the SML is undervalued: 10.2% vs 13.8%
A stock with a beta of 1.2 is expected to return 12.0% when the risk-free rate is 3.0% and the expected market return is 9.0%. A candidate who multiplies beta by the market return gets a required return of 13.8% and calls the stock overvalued. The required return is 10.2%, the stock plots above the security market line, and it is undervalued.
What the SML actually prices
The security market line is the CAPM drawn as a graph. Required return sits on the vertical axis, beta on the horizontal one. The intercept is the risk-free rate and the slope is the market risk premium.
Required return = risk-free rate + beta × (expected market return − risk-free rate)
Beta is the only risk input. Total volatility does not appear anywhere in that expression, which is the whole point: the line prices systematic risk and ignores the part a diversified investor can eliminate for free. A stock can be wildly volatile and still sit low on the SML.
The premium is a difference, not the market return
The slope term is a subtraction, and dropping it is the most expensive keystroke in this topic. With a 9.0% market return and a 3.0% risk-free rate, the market risk premium is 6.0 percentage points, not 9.0.
Correct: 3.0% + 1.2 × (9.0% − 3.0%) = 3.0% + 7.2% = 10.2%
Incorrect: 3.0% + 1.2 × 9.0% = 3.0% + 10.8% = 13.8%
The gap is 3.6 percentage points, which is beta multiplied by the risk-free rate. That is not a coincidence. Forgetting the subtraction adds the risk-free rate back into the slope, so the error scales with beta and the mistake grows for exactly the aggressive stocks a question is most likely to use.
Look at what 13.8% does to the conclusion. An expected return of 12.0% now falls short of the required return by 1.8 points, the stock looks like it is priced to disappoint, and the answer flips from buy to sell. The arithmetic slip does not produce a slightly wrong number. It produces the opposite recommendation, and that answer is sitting there in the choices.
Above the line, below the line
Alpha is the vertical distance from the line: expected return minus required return. Positive alpha means the asset offers more than its systematic risk justifies, so it plots above the SML and is undervalued. Negative alpha plots below and is overvalued. Fairly priced assets sit on the line with alpha of zero.
Take two stocks against the same 3.0% risk-free rate and 6.0% premium.
Stock A: beta 1.2, expected 12.0%. Required = 3.0% + 7.2% = 10.2%. Alpha = +1.8%
Stock B: beta 0.8, expected 6.0%. Required = 3.0% + 4.8% = 7.8%. Alpha = −1.8%
Stock A is above the line and Stock B is below it, by the same 1.8 points in opposite directions. Notice that Stock A has both the higher beta and the better verdict. Higher risk did not make it a worse buy, because the SML has already charged it for that risk. Candidates who remember the rule backwards usually remember it as "above the line means expensive", and the word expensive is doing the damage.
The SML is not the CML
The capital market line looks similar and answers a different question. Its horizontal axis is standard deviation, which is total risk, and only efficient portfolios lie on it. The SML uses beta, and in equilibrium every asset belongs on it, individual securities included.
So a single stock plotting below the CML says nothing about mispricing. Almost every individual stock sits below the CML, because it carries diversifiable risk that earns no reward. Only the SML supports a valuation conclusion.
Quick reference
| Question wording | What it establishes | Risk if missed |
|---|---|---|
| Expected market return | Subtract the risk-free rate to get the premium | Overstating required return by beta × risk-free rate |
| Market risk premium | Already the difference, use it as the slope directly | Subtracting the risk-free rate a second time |
| Plots above the SML | Positive alpha, undervalued, buy | Reading "above" as expensive |
| Plots below the SML | Negative alpha, overvalued, sell | Reading "below" as cheap |
| Standard deviation on the axis | It is the CML, efficient portfolios only | Drawing a valuation conclusion from the wrong line |
The reliable habit is to write the required return before forming any opinion about the stock. Compute the line first, then compare. Candidates who eyeball the expected return against the market return skip the only step that uses beta at all, and beta is the entire question.
The same discipline shows up in portfolio risk calculations, where the inputs also look ready to combine before the correct measure has been identified.
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