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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.

What is Security Market Line (SML)?

The security market line or SML represents the CAPM model graphically. This is something which shows in the relationship that exists between the 2 techniques, namely security market line and the capital market line. This shows the relationship between the return that an investor derives from a security and the risk which is associated with it and is ultimately measured by the beta coefficient. Another way of saying the same is the fact that the securities market line help in deriving the expected rate of return from the beta which is already given and also reflects in the risk or the riskiness which is connected or is associated with the given rate of return in terms of the security (Bawa, 2018).

The X axis of the below stated graph shows in the beta and the Y axis shows in the expected rate of return. The value of the risk free rate of return starts with the beginning of the line.

In case, an investor holds the security which is in treasury bonds or is a security of any government, then the investment shall have 0 beta or 0 riskiness and hence, the rate of return on that investment would be the return that has no risk attached with itself. Rate of return expected on that investment shall be 0 beta portfolio which would be equal to the risk free rate of return.

The slope of this security market line is the result of the risk premium in the market which exists in respect of the security which indicates the difference between the risk free rate of return and the expected rate of return on the market. The relationships exists as is the more the market risk premium, the steeper would be the slope and vice versa.

This security market line I never fixed and it all depends upon the changes in the rates of interest in the market and the relationship which exists between the risk and return and the risk and return trade off (Ross, 1985). Hence, the position of the security in the market would change if the coefficient changes of that security in the market over the period of time.

There would be a change in the SML if there is a change in the expected rate of inflation or the GDP or the rate of unemployment.

But this line is also criticised on many grounds. The first being the fact that it is based on the similar assumptions. The investors in the market have some different abilities when it comes to borrowing of the money at the rate of interest which is risk free and also, the fact that the transaction costs are very different. Hence, the real conditions in the market can never be stated to be have strong efficiency. Therefore, in the real world, the position of the stock could either be above or be below the SML as could be seen in the below drawn figure:

Hence, the above graph shows in the actual values of the betas along with the expected rate of returns on these stocks that would just look like the points instead of a single line. The stocks that are there above this drawn line are the stocks that are undervalued. The main reason behind the same is the fact that there is a higher rate of return for any given risk rather than the CAPM assessment. And in case, these stocks are shown below the security market line, then it can be stated that these stocks are overvalued. This is merely since these require in the lower rate of return for the given risk which could be assessed by the CAPM model (Financial management pro, 2018).

Graphical representation of SML

This is the market line which shows in the expected return of the portfolio. The portfolio comprises of all of the possible securities between the market portfolio and the asset which has no risk involved with it. The portfolio in the market is completely diversified. It also carries in the systematic risk along with the expected rate of return along with the expected market return in its entirety (Hogan, 1974). This return on these portfolio could be less than or could be equal to the market rate of return, in case, the portfolio is equal to 1 or 100%. But it is also true that the return on these leveraged portfolios would be more than the market ate of return.

Again, this is criticised on many grounds. There are many of the taxes and the transaction costs involved, which could significantly vary amongst the different investors.  It is also true that an investor could lend or borrow money at an uncertain rate of risk which could be termed as the risk free rate of return. In the real world, it is often seen that the investors can borrow at the rate which is higher rate than at what they lend the money. This is the concept which brings in the CML in picture.

It is further criticised on the grounds that real markets do not form a strong form of efficiency, hence these investors have an access to a very little amount of information. Also, bot all of the investors are willing to take risks. The concept of riskiness of any security which is shown as the standard deviation is not the only way of calculating the risk.

There are as such no assets that have no risk attached to them.

It is therefore, for these reasons it is stated that CML is more like a distorted line rather than just a precise line.

The minimum variance frontier which comprises of all of the risky portfolios that have the minimum amount of the risk at a level of an expected rate of return. The X axis shows the standard deviation of the return of the securities which is also the riskiness of the securities and the Y axis shows in the expected rate of return of the securities.  Any asset which is not exposed to risk is never shown in the portfolio wince it carries no risk (Gatech, 2018). The portfolio which is the farthest on the left side would be considered to be of the minimum variance frontier whereas the portfolio which is on the minimum variance frontier is termed as the optimal portfolio.

The portion which lies on the above of the global minimum variance portfolio or which exists on the upper half of the minimum variance frontier is often termed as being in the efficient frontier.

Herein, the X axis comprises of the standard deviation of the returns on the assets and the Y axis comprises of the expected return from these assets. Any security which exists on the efficient frontier would be termed as the efficient portfolio. All the efficient portfolios are optimal but the vice versa is not there or is not correct.

Capital Market Line (CML)

CML is also termed as the largest Sharpe ratio which is the line which is parallel to the efficient frontier and also the tangency point which is known as the market portfolio.

SML is the line which runs from the risk free asset through in the market portfolio to the infinity.

The minimum variance portfolio is of an utmost importance since an investor would want to invest in an investment wherein there is lesser risk and lesser return and then there are investors that may go for more return, more return. Hence, this market portfolio would show in the exact composition of the portfolios as per the needs of each one of the investor.

The capital market line shows all of the portfolios that could cater to the needs of the different investors. The efficient frontier shows in all of the combinations of the investments that could be efficient and this could include in the risky assets in the various different proportions.

(Financial management pro, 2018).

The CM stands for Capital Market Line whereas SML stands for the Security Market Line.

The CML shows in the different rates of returns that is dependent upon the different risk free rates of returns along with the levels of risks for any specific portfolio.

SML on the other hand is the Characteristics line which shows in the representation of the risks and the return at any point of time. The main difference between the two is the way through which both of them are measured. CML shows the measurement of risk by standard deviation whereas CML shows the risk through the calculation of beta (Gorrin, 2017).

The CML helps in the measurement of risk all through the way of calculating the standard deviation or through the total risk factor whereas the SML helps in the measurement of risk through the way of beta that could help in finding the risk contribution of the security for the portfolio.

On one hand, the CML shows in the efficient portfolios while on the other, SML shows in the efficient along with the portfolios that are non-efficient.

The market portfolio along with the assets that do not have any risk attached with them are determined by the CML and the security factors are determined by the SML.

The CML shows in the consolidated or the aggregated return on the assets whereas SML shows in the returns from individual assets (Management note, 2018).

The CML indicates the risk or the return which is associated with the efficient portfolios whereas the SML indicates the risk or the return which is associated with the individual stocks (Boundless, 2018).

It is because of these reasons, CAPM is considered to be superior than the SML.

In the nutshell, the CAPM identifies in two important forms of compensation, on being time value for money and the other being risk. The arte of risk free investment is the formula which shows in the time value of money and also is in line with the investors for the purposes of placing in the money in any investment over the period of time. This is the risk free return on the US Treasurer or the bonds that are issued by the government.

The CAPM model also helps in the calculation of the compensation and the risk that would help the investor in taking on some additional risk.

This model shows in the expected rate of return on the security of the portfolio which is somewhat equal to the rate on the risk free security along with the risk premium.

It states that in case, this rate of return beats in the required rate of return, then the investment must never be undertaken. Whereas the SML plots in these results derived from CAPM for all of the different risks or betas (Corporate finance institute, 2018).

CAPM considered the systematic risk along with the unsystematic risk that could easily be diversified which is not the cash with SML. CAPM also creates in a theoretical relationship which exists between the risk and the rate of return from any portfolio which is again not the case with SML (educba, 2018).

References:

Corporate Finance Institute. (2018). What is CAPM - Capital Asset Pricing Model - Formula, Example. [online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-the-capm-formula/ [Accessed 6 Sep. 2018].

Courses.lumenlearning.com. (2018). Understanding the Security Market Line | Boundless Finance. [online] Available at: https://courses.lumenlearning.com/boundless-finance/chapter/understanding-the-security-market-line/ [Accessed 6 Sep. 2018].

EDUCBA. (2018). How Important Is CAPM (Capital Asset Pricing Model) and Its Calculations?. [online] Available at: https://www.educba.com/capm-capital-asset-pricing-model/ [Accessed 6 Sep. 2018].

Financialmanagementpro.com. (2018). Capital Market Line – CML | Definition | CML Equation | Graph | Examples | Efficient Frontier. [online] Available at: https://financialmanagementpro.com/capital-market-line-cml/ [Accessed 6 Sep. 2018].

Financialmanagementpro.com. (2018). Security Market Line, SML | Definition | CAPM model | Equation | Example | Graph. [online] Available at: https://financialmanagementpro.com/security-market-line-sml/ [Accessed 6 Sep. 2018].

LSE Finance Job Market Candidate | London | Jesus Gorrin. (2018). Capital Market Line (CML) vs Security Market Line (SML) | LSE Finance Job Market Candidate | London | Jesus Gorrin. [online] Available at: https://www.jesusgorrin.com/single-post/2017/10/11/Capital-Market-Line-CML-vs-Security-Market-Line-SML [Accessed 6 Sep. 2018].

Management Notes. (2018). Difference between Capital Market Line(CML) and Security Market Line(SML) | Finance - Management Notes. [online] Available at: https://www.managementnote.com/difference-between-cml-and-sml/ [Accessed 6 Sep. 2018].

Www2.isye.gatech.edu. (2018). Mean-Variance Portfolio Analysis and the Capital Asset Pricing Model. [online] Available at: https://www2.isye.gatech.edu/~shackman/isye6225_Fall_2011/MVA_CAPM.pdf [Accessed 6 Sep. 2018].

Bawa, V. (1977). Capital market equilibrium in a mean-lower partial moment framework. [online] Available at: https://www.sciencedirect.com/science/article/pii/0304405X77900174 [Accessed 12 Sep. 2018].

Hogan, W. (1974). Toward the Development of an Equilibrium Capital-Market Model Based on Semivariance. [online] www.cambridge.org. Available at: https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/toward-the-development-of-an-equilibrium-capitalmarket-model-based-on-semivariance/795CEF1CD80A2F8C3A5A3C8276EA6654 [Accessed 12 Sep. 2018].

Ross, S. (1985). Differential Information and Performance Measurement Using a Security Market Line. [online] onlinelibrary.wiley.com. Available at: https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1985.tb04963.x [Accessed 12 Sep. 2018].

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