Background: The Capital Asset Pricing Model (CAPM) posits a linear relationship between the risk of an investment and its expected return, characterized by the Security Market Line (SML). Previous research, including Frazzini and Pedersen (2014) and Jylhä (2018), has shown that leverage constraints flatten the SML. Miller (1977) and Hong and Sraer (2016) showed with theory and empirical research that short-selling constraints also flattened the SML. This study investigates the impact of the UCITS III directive, which relaxed leverage and- short-selling constraints, on the SML in the Swedish stock market (OMXSPI).

Purpose: This thesis aims to analyze whether the implementation of the UCITS III directive in Sweden has influenced the security market line (SML), thereby altering the risk-return dynamics for Swedish stocks.

Method: The study employs a Difference-in-Differences (DiD) methodology, comparing pre- and post-UCITS III periods for Swedish stocks listed on the OMXSPI index with a control group of US stocks from the S&P 500 index. Betas and excess returns were calculated using OLS regression for the periods between 1st of Januari, 2002 and 30th of December, 2005 to assess changes in the SML.

Conclusion: The anticipated steepening of the Swedish security market line (SML) following the introduction of UCITS III was not observed, potentially due to the limited influence of UCITS funds, data constraints, or the timing of implementation. Although theory suggests that relaxing leverage and short-selling constraints should steepen the SML, this effect could not be demonstrated in this study.

Future Research: Future studies should address these limitations by expanding the geographical scope to include more EU member states and examining how mutual fund balance sheets were affected by UCITS III. Using more randomized stock samples or applying extended models such as the Fama-French three-factor or five-factor models would also provide a more comprehensive understanding of how regulatory frameworks like UCITS III shape market behavior and investment strategies.