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.
The following report states that the CML is related to the SML. It also states the differences between the capital market line and the security market line. The security market line is a virtual representation of the capital market line.Its risk is measured by a beta coefficient . CML is a graph that reflects the expected portfolio . This portfolio consists of all possible allocations that are present between the market portfolio and a risk free asset. The report goes into a slightly deeper analysis of the two and explains the main differences related with it. Then it discusses the concept of minimum variance portfolio and its importance in choosing stocks that optimise return and minimise risks. Finally it illustrates the relevance of CAPM and its usefulness in computing the return of a particular stock.
CML VS SML
The CML usually depicts the rate of return on theother hand SML is a line that is a graphical symbol of the market risk at a fixed point of time. The SML depends on the rarte of return that is risk freeand on the associated levels of risk that is present in a portfolio. The capital market line can be measured with the help of standard deviation.The beta coefficient, on the other hand determines the risk for SML. Standard deviation measures the risk for SML. The security’s risk combination for the portfolio is evaluated by beta. The graphs od SML helps to define both the efficient and the non efficient portfolios and on the other hand the graphs of capital market line helps to describe only efficient portfolios.(Jylhä 2018).
When a return is calculated , the return of the portfolio which is expected is drawn on the Y axis along with th return on the securities.. The X axis shows the standard deviation portfolio for the CML. The beta of security is shown along with the X axis(Christensen, Hail, and Leuz 2016).
Figure 1- CML VS SML
Source- (Christensen, Hail and Leuz 2016.)
The risk free assets and marketing portfolio are shown by CML. The SML determines the security factors. The Security Market Line displays the expected return of individuals.
Thus the differences can be considered as follows:
1.The rate of return is shown by CML which also depends on the rates of return which is risk free. At a given period of time, SML shows the risk and return.
2.Standard deviation of the measure of risk for CML. The risk factors of SML are determined by beta .
3.The capital market line determine efficient portfolios . The Security market line, on the other hand determine both efficient and non efficient portfolios.
4.Capital market line helps in determining the market portfolio and the risk fee assets. All security factors on the other hand is determined by the security market line(Jylhä 2018).
Minimum Variance Portfolio
Minimum variance portfolio
The performance of the equity portfolios are optimised in such a way that it can have variances of a lowest nature. Minimum variance strategies are addressed towards increasing obligation for management of risk . This is because of the financial crisis . Another reason that can be attributed is the fact that stocks of low volatility have a tendency to exhibit returns that meet or surpass the market. The popularity of low volatility performance portfolio and strategies exploit equity market anomalies.
The overall volatility of other equity portfolios gets affected if an investor is concerned about the possibility of significant drawbacks. They may desire to have stocks that have reduced volatility. They also want to maintain a full and balanced exposure in respect of the pertinent equity benchmark. In this case the investor might characterise the investor as risk aware. In this case an investor will possibly not turn to low volatility indexes. This is because of the degree of difficulty. This difficulty will be between choosing market capitalisation based weighting schemes. These schemes are not intended to reduce the required amount of volatility . The non capitalisation weighting approaches can achieve substantial volatility reduction. The investor may decide to. reduce the aggregate level of volatility. However at the same time they would want to control the secondary exposures using optimisation techniques(Yang, Couillet and McKay 2015).
Figure 2- minimum variance portfolio
source-( Bodnar, Mazur and Okhrin 2017)
As per the graph , modern portfolio theory recommends that there is a tangent to optimal investment portfolio. This optimal level of portfolio is the level where the capital allocation line meets the efficient frontier. A risk averse investor wants such a portfolio on the efficient frontier that not only has the highest possible return but also the lowest possible variance. When there is a presence of low volatility, investors can attain aportfolio which is present above the frontier which will be efficient. These might have a huge return than the expected return corresponding to the risk which is given.
The importance of the minimum variance portfolio theory can be summed up as follows:
1.The securities that have low volatility or low beta experience attains a higher rate of return compared to stocks that have high voilatilty or high beta.
2.It tends to be more robust during market downturns. Once the business cycle ultimately makes a recovery then that minimum variance portfolio tends to show a performance that compounds over time..
3.The minimum variance portfolio suggests that the returns should outdo the capital weighted market portfolio( Bodnar, Mazur and Okhrin 2017). CAPM
It is a model that best defines the relationships between systematic risk and expected return for assets. It is mostly used to value risky securities. Further it is also used to generate expected return for assets. The risks of these assets and their corresponding costs of capital are given.
The main idea behind this model represents the risk. It also calculates the compensation amount that the investor needs to take to sustain extra risk . This can be done by using beta as a risk measure . Beta makes a comparison of the return of the asset by comparing it to the market return over time . It takes into account the market premium . It also considers the excess of market return over the risk free rate. Beta is a reflection of the riskiness of an asset . This risk is compared to the volatility of the market and the asset. Then these two are being correlated. The model also states that the expected return of a security or portfolio is the same compared to the risk free security rate .It also incorporates a risk free premium. After analysis, if it s found that the expected market return does not meet or beat the required return then it would be wise not to undertake the investment decision (Campbell et al. 2018).
Diversified portfolios- This assumption signifies that investors will require a return for systematic risk . This is because there can be presence of diversification of the unsystematic risk which cannot be ignored
Single period transaction - CAPM assumes a standardised holding period. This is so that it can make the return on different securities comparable. A holding period of one year is normally considered.
At the risk free rate of return investors can both borrow and lend-This requires a minimum level of return. This return is required by investors for investment purposes. The connection of the security market line and the Y axis is termed shows the rate of return which will be risk free. The security market line is a graphical representation of the CAPM model
When all the securities are accurately valued at the appropriate rate, then it is termed as a perfect capital market. The returns will be framed in the security market line. It is assumed in a perfect capital market that there is an absence of transaction cost and tax .It also makes the assumption that information of a pefect nature is freely available to all investors . For this reason, expectation can be stated as rational and risk averse . Soundly established stock markets do possess a high degree of efficiency . The assumption of a one year holding period appears reasonable from the perspective of the real world. This is reasonable despite the fact that many investors hold securities longer than a year, The return on securities are usually mentioned annually.
Assumptions of CAPM
Owning stock market portfolio is impossible. Although it is not very difficult and expensive for expanding the unsystematic risk for investors. With the help of this portfolios can be created which will help in tracking the stock market. Sometimes it becomes difficult for the investors to take money . The reason for that is the government associated risk. Not being abl to borrow at the risk free states that actually the slope of tue security market line is much more flimsy when seen theoritically. Therefore, it can be concluded by saying that the assumptions which is related to the CAPM model is only idealised which is not based in the actual world. There can be an existence of a relationship which may be linear, between systematic risk and required return in the actual world.(Barberis et al. 2015).
Benefits of the CAPM
The following reasons explain how CAPM is much more specific while calculating the required rate of return. These include:
CAPM takes into account systematic risk only. It also reflects a reality where most investors have diversified portfolios. These portfolios consist of those from where the elimination of unsystematic risk has been done.
The particular model shows a connection between the rate of return that is required and the systematic risk. The model is also subjected to repeated testing and empirical findings.
Therefore, it is better to calculate the method of computation of equity cost than using the dividend growth model. The cost of equity will aslo calculate the amount of systematic risk that the company will have. It is considered that the risk is related to the stock market as a whole. The CAPM models is therefore a much more effective method that applies to all investment methods(Barberis et al. 2015).
From the report it is evident that the SML is very different than the capital market line . From minimum variance portfolio analysis , it is evident that the minimum variance portfolio analysis is suitable for choosing stocks that have optimum returns and minimum variance in risks. The CAPM is therefore more accurate than the other equations when the rate of return is to be calculated. It helps in assessing the return on asset by comparing the beta which is a measure of systematic risk . This systematic risk is incorporated while computing the rate of return on a security using the CAPM. It also helps in computing the cost of equity.
Barberis, N., Greenwood, R., Jin, L. and Shleifer, A., 2015. X-CAPM: An extrapolative capital asset pricing model. Journal of financial economics, 115(1), pp.1-24.
Bodnar, T., Mazur, S. and Okhrin, Y., 2017. Bayesian estimation of the global minimum variance portfolio. European Journal of Operational Research, 256(1), pp.292-307.
Campbell, J.Y., Giglio, S., Polk, C. and Turley, R., 2018. An intertemporal CAPM with stochastic volatility. Journal of Financial Economics, 128(2), pp.207-233.
Christensen, H.B., Hail, L. and Leuz, C., 2016. Capital-market effects of securities regulation: Prior conditions, implementation, and enforcement. The Review of Financial Studies, 29(11), pp.2885-2924.
Jylhä, P., 2018. Margin requirements and the security market line. The Journal of Finance, 73(3), pp.1281-1321.
Yang, L., Couillet, R. and McKay, M.R., 2015. A robust statistics approach to minimum variance portfolio optimization. IEEE Transactions on Signal Processing, 63(24), pp.6684-6697.
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