Difference Between Security Market Line And Capital Market Line, Importance Of Minimum Variance Portfolios And Relevance Of CAPM Equation

Explain and graphically depict how Security Market Line (SML) is different from Capital Market Line (CML). Identify and discuss the importance of minimum variance portfolios? Why CAPM equation might be more relevant than other equations when calculating required rate of return. 

CAPM method and the graphical representation of CML and SML

This report shows the graphical presentation of the undertaken security market line and capital market line. It shows how CAPM method is used to compute the required return of the investors. The graphical representation of the CML and SML will help investors to assess the low risk and high return on his investment. The main issue in computing the right amount of cost of capital in particular project is based on setting the risk free rate of return. Many investors might face issue to undertake the right base at which it will reflects the exact cost of capital and return associated with the particular accepted project. This essay will focus on the graphical representation of the CML and SML and the computation of the cost of capital through the CAPM method.

In CAPM, Capital Market Line is determined when in portfolio there is trade-off between risk and return, it refers to as CML. This helps in determining the optimum point where company could have optimum risk and return associated with the particular project.  On the other hand, security Market Line is formulated to determine the market risk related to the marketable securities against the expected return.  It is an investment evaluation tool which helps to evaluate systematic and systematic risk associate or plotted against the expected rate of market return plotted at the single point. In CML risk is measured and plotted on graph CML graph portray efficient portfolios while in SML both efficient and non-efficient portfolios are depicted by the graph. It is analyzed that where SML determines all the security related factors ,market portfolio and risk free assets are determined by CML. Risks or return for individual assets/stocks are determined by SML while risk or return for efficient portfolios are shown by CML. The main Importance of minimum price variance portfolio is related to determine the expected return, risk of individual risky assets (Brigham, and Ehrhardt, 2013).

In these two different cases, relation between the risk and return associated with the investment projects has been determined. In case of model of Sharpe, liner against the case is free from sharp liner and return is associated with the premium and beta of the market. It is analyzed that in case of the risky assets and unrestricted shorts selling of the risky portfolio there might be chance of the high risk and beta associated with the project.  The main assumption which is determined is that the premium beta is positive and expected return on the market (Cikaliuk, et al. 2017).

Importance of minimum variance portfolios

(Source: Prezi 2017)

This diagram shows the CML and SML of the invested return. It is considered that capital market line reflects the trade-off between the return and risk of the invested capital. In case of the CML, investors choose the position on the CML in equilibrium by borrowing or lending at the risk free rate (Dahir,  Mahat, and Ali, 2018). The SML could be described as graphical presentation of the CAPM model. It is analyzed that if the expected return of the security is plotted over and above the SML line then it is determined as undervalued and if it is not given then it will set up risk return trade off.  These two graphs are drawn individually with a view to make the proper graphical presentation and reflect the modes at which investors will have optimum return with the given level of risk (Yahoo finance, 2018).

It is considered that diversified portfolio contains the assets that are accompanied with the high risk on the individual basis but also have lower level of risk related to anticipated risk return when pooled together.

In minimum variance portfolio, expected return and risk level of individually risky assets are at the lowest and individual portfolios are more risky than the portfolio as a whole. When the assets are pooled together they help us to get more benefit and high return.  It helps to possibly minimize price volatility in portfolios.  .    

The capital assets pricing model is used to identify and evaluate the financial performance of company. Ideally, capital assets pricing model is used to evaluate the cost of capital and accepting the best possible projects in the undertaken project. It is analyzed that when we want to establish relationship between RISK and expected return of investing in a security than we usually use CAPM model

The main relevancy of using the CAPM equation is related to time value of money and cost of capital used in the particular project.

The idea behind using CAPM Model is to get two kinds of compensation: time value of money & risk. As we all know that no model is perfect but CAPM Model somehow developed more accessible approach to diversification. It takes into the account systematic risk which is not taken by other return models. (Systematic risk or market risk is also known as “un-diversifiable risk’. This un-diversified risk is comprised of entire market segment having inherent uncertainty i.e. Fluctuations in the market occur every so often). It reduces the unsystematic risk (this kind of risk is associated with the company we have invested in) and provides diversified portfolio. CAPM model’s calculation is simplistic and it provides probably all the possible range of outcomes around the required rate of return with a sense of confidence.

Relation between the risk and return using different models

When other required rate of return calculations cannot be used in business and other financial risk variability than CAPM calculations can be used. Investors looking to maximize growth in the portfolio should maintain a larger location to risky assets and this can be made possible by CAPM Model. The risk free rate of return is determined on the basis of return available on the treasury bonds and gilt securities and risk premium market is determined on the basis of market risk associated with the industry. The beta of company is determined on the basis of the share price movement of the company and all ordinary share price index. However, the computation of the beta is based on the share price fluctuation and all ordinary share price movement. It is computed by using the regression analysis model in both the share price movement.

This could be depicted by using the clear example such as if the risk free rate of return of company is 2% and market beta of company is 1 and the expected market return is 12% then in this case the company could be having expected rate of return or cost of capital 28%

In case of accepting the particular project, CAPM model is very much useful. Investors while using the CAPM model needs to establish the relation between the risk and return related to the accepted project. It is analyzed that investors could choose only those portfolios which have low variances and specific expected return and cost of capital.  This model is known as Markowitz model (Fard, and Falah, 2015).

(Source: Capital assets pricing model, 2017)

Figure 1 The above given chart reflects that if the CAPM amalgamated with the efficient frontier and extended lines for the risk free rate of return point and the extended line for risk free return points on y axis (Fernandez, 2015).  The inequality of the borrowing and rate determined for the purpose of lending.  This frontline helps in identifying the plausible causes of difference between the risk and return of the accepted project.  It is analysed that mean variance efficient with the frontier with the riskless assets is determined on the basis of the risk and associated return with the particular project. Investors would accept those projects which will offer higher return with the minimum risk model. This is hard to find the optimum investment point which could strengthen the overall outcomes of the investors in context with the investment option (Prezi. 2017). The above given graphical representation reflects the changes in the return with the increase risk of the particular accepted project.

After analysing all the details, crux of this research report is that these both SML and CML are used to determine the relation between the cost and return of the company while accepting the particular project. It is analysed that if investors wants to invest his capital then it could do so by keeping its money invested in long run if the market risk premium is high. There are several other models which might be used by investors to find out its own economic point at which it could have its return or risk as per their acceptance in related to risk and return of the particular project. Therefore, investors while analysing the SML and CML need to identify the market line first then the further comparison between both should be made. Market Line is formulated to determine the market risk related to the marketable securities against the expected return. This reflects the true base for the comparison in both. The CAPM model has several advantages and benefits associated with the computing the return and risk associated with the project.  This model does not only consider the systematic risk and unsystematic risk which company might face in its business. There are several other models which could be used by the researchers while computing the cost of capital such as dividend growth model, Gordon Model (Zhu, 2014). 

References

Brigham, E.F. and Ehrhardt, M.C., (2013). Financial management: Theory & practice. 2^nd ed. Australia: Cengage Learning.

Capital Assets pricing model, (2017) Capital Asset Pricing Model (CAPM)? [Online] Available from https://accountingexplained.com/capital/equity-valuation/capital-asset-pricing-model [Accessed on 14th September 2018]

Cikaliuk, M., Erakovic, L., Jackson, B., Noonan, C. and Watson, S., (2017). Board Leadership for Strategic Transformation: Aligning Diversity Initiatives at the Bank of New Zealand. 3(1), pp.21-32.

Dahir, A.M., Mahat, F.B. and Ali, N.A.B., (2018). Funding liquidity risk and bank risk-taking in BRICS countries: An application of system GMM approach. International Journal of Emerging Markets, 13(1), pp.231-248.

Fard, H.V. and Falah, A.B., (2015) A New Modified CAPM Model: The Two Beta CAPM. Jurnal UMP Social Sciences and Technology Management Vol, 3(1). pp.23-28.

Fernandez, P., (2015) CAPM: an absurd model. Business Valuation Review, 34(1), pp.4-23.

Prezi. D, (2017) CAPM: Assumptions and Limitations | Securities | Financial Economics [Online] Available from https://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-limitations-securities-financial-economics/29904 [Accessed on14th September 2018]

Yahoo finance, (2018), Online] Available from https://in.finance.yahoo.com/[Accessed on 14th September 2018]

Zhu, J., (2014). Quantitative models for performance evaluation and benchmarking: data envelopment analysis with spreadsheets 17(2), pp.231-248.