SML Still Works with Different Borrowing Rates?

Imagine the Security Market Line, or SML, as a kind of ideal roadmap for investing. This roadmap helps us understand the relationship between risk and expected return in the stock market. Ideally, this roadmap is drawn assuming a perfect world where everyone can borrow and lend money at the same risk-free interest rate. Think of this risk-free rate like the interest you might earn on a very secure government bond. In this perfect world, the SML plots a straight line upwards. The higher the risk of an investment, measured by its beta, the higher the expected return should be, according to the SML.

However, the real world isn’t perfect. One key way it deviates from this ideal is that borrowing and lending rates are not identical for everyone. When you want to borrow money, say for a mortgage or a loan, you often face a higher interest rate than what you would receive if you were lending money, for instance, by putting it in a savings account or buying those government bonds. Furthermore, these rates can vary depending on who you are, your creditworthiness, and the type of loan. Large institutions often get better borrowing rates than individual investors, for example.

So, if borrowing and lending rates aren’t the same for everyone, and especially not the same as the risk-free rate used to construct the ideal SML, why can the SML still be useful? The answer lies in the power of market forces and the concept of relative valuation.

Even if the absolute level of the SML might be slightly off because of differing borrowing and lending rates, the relationship it describes, the upward sloping line between risk and expected return, still holds reasonably well. Think of it like this: even if your roadmap isn’t perfectly calibrated in terms of distance, it still shows you the correct direction to get to your destination.

Here’s why this approximation works. Imagine a scenario where an asset’s expected return is significantly above the SML, even considering the differences in borrowing and lending rates. This would make the asset look very attractive. Investors, seeing this opportunity, would rush to buy this asset. Increased demand for the asset would drive its price up. As the price goes up, the expected return, calculated as future cash flows divided by the current price, will decrease. This process continues until the expected return aligns more closely with the SML, or at least within a reasonable range around it.

Conversely, if an asset’s expected return is significantly below the SML, it would appear unattractive relative to its risk. Investors would sell this asset, causing its price to fall. As the price falls, the expected return increases, again pushing it back towards the SML.

This buying and selling pressure, driven by investors seeking to maximize their returns, acts as a self-correcting mechanism. It constantly pushes asset prices and expected returns towards a risk-return relationship consistent with the SML, even if the baseline risk-free rate assumption is not perfectly met in reality.

While the SML might not be a perfectly precise tool in a world of varying borrowing and lending rates, it remains a valuable benchmark. It provides a framework for understanding how risk should be compensated with expected return. It helps investors identify assets that might be potentially mispriced relative to their risk, even if those mispricings are not as clear-cut as they would be in a perfect market. The SML, therefore, serves as a reasonable approximation and a useful guide for investment decisions, even when the ideal conditions of identical borrowing and lending rates are not fully present. It’s less about pinpoint accuracy and more about understanding the general direction and relative value in the market.