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.
Understanding the differences between Capital Market Line and Security Market Line
Investors use different type of techniques for evaluating the current valuation of the stock and detect viable investment scope, which helps in strengthening their portfolio. The different valuation such as CAPM model, minimum variance portfolio, capital market line and security market line is used for enhancing their exposure in the capital market. investors utilize the methods such as technical and fundamental analysis to identify the investment scope, which could allow them to mitigate the risk involved in investment, while raising the level of written that could be generated from the exposure. The use of security market line allows investors to identify the overvalued and undervalued stocks, which mainly helps in improving the returns from investment. Therefore, with the help of capital market line and minimum variance portfolio investors are able to detect the level of risk of portfolio can income to generate the targeted returns. The assessment evaluates the above theories and techniques, which allow investors to support their exposure in the capital market.
Figure 1: Capital Market Line Graph
(Source: Zhou, Simnett and Green 2017)
Figure 2: Security Market Line Graph
(Source: Dash 2017)
The graph depicted in the above figure relatively represents the risk and return attributes of two different measures, which are used by investors to formulate their investment strategy. The measure that is used by capital market line directly allows the investor to formulate an adequate portfolio, which can generate the expected returns from a certain level of risk exposure. Furthermore, the Security Market Line graph directly allows the investor to detect that the stock is undervalued or overvalued, which help them to improve their exposure in the capital market (Jerkins 2017). However, from the evaluation of above graph certain differences between the capital market line and security market line can be identified, which are depicted as follows.
- The first difference that can be identified between security market line and capital market line is the use of different risk attributes. The different genres attributes directly alters the level of expected return, which is derived by both the techniques. therefore it could be understood that capital market line uses standard deviation derive the risk condition of the stock, while security market line uses beta to address the risk attributes of the investment.
- The second major difference between the CML and SML is the output range, which is the detected after the calculations, has been conducted. The capital market line directly allows the investor to identify the range of risk and return attributes of a particular portfolio. On the other hand, security market line directly indicates the condition of the stock and detect whether they are undervalued or overvalued. The difference in the risk detection attributes of body measures plays a significant role in the overall output (Means 2017).
- The third major differences between the measures are the different level of evaluations that is being conducted by SML and CML. The security market line directly used only once talk to measure its current condition in the market. However, the Capital Market Line uses of portfolio, which consists of several stocks to determine the risk and return, attribute of the investment scope. This type of difference directly indicates that with the help of security market line investors are able to understand the risk and return attribute of a particular stock, while capital market line provides an insight on the total portfolio of the investor. These changes would eventually allow different types of investors to understand the significance of both the measure and its usage under changing circumstances (Dekker 2017).
- The fourth major differences between the Security market line and capital market line is the alternating measures that are used by both the techniques in supporting the investment scope. The security market line eventually allows the investor to understand both Systematic and unsystematic risk associated with an investment. On the other hand, the capital market line directly depicts the level of systematic risk, which is involved in the particular portfolio (Arrow 2017).
- Investors by using the capital market line are able to create an adequate portfolio eating their investment and risk requirement. On the other hand, the security market line only portrays the current position of a particular stock and depicts whether it is overvalued or undervalued. therefore, the investment scopes is also a difference between the capital market line and security market line, as investors altering investment scope uses different measures for controlling their exposure in the capital market (O'connor 2017).
Figure 3: Minimum variance portfolio graph
(Source: Bodnar, Mazur and Okhrin 2017)
The minimum variance portfolio graph is adequately depicted in the above figure, which relatively allows investors to identify an adequate, which structure to support their investment criteria. Minimum variance portfolio is considered to derive an adequate weightage of different stock, which would reduce the level of risk involved in investment, while maximizing the return capability of the portfolio. The graph depicted in the above figure directly represents a certain risk, which indicates the different combination of portfolio weights that could be used by investors to reduce or increase their risk exposure as and when they need to raise the level of returns (Cui, Li and Li 2017).
Understanding the significance of minimum variance portfolio
Minimum variance portfolio contributes to a positive attributes of investors where it has significant value, which are depicted as follows.
- The major significance of minimum variance portfolio is its contribution to formulate an adequate portfolio, which has the lowest risk involved in investment. This type of measure directly allows the investor to minimize the level of risk exposure of their investment in the capital market. Furthermore, the reduction in risk attributes of an investment directly allows the investor to ensure the security of their investment capital, which would eventually generate secure returns from investment (Bessler, Opfer and Wolff 2017).
- The minimum variance portfolio also allows the investor to detect the level of investment that need to be conducted on each stocks consisting in the particular portfolio. This detection of investment weights would eventually allow the investor to reduce the negative impact of volatile capital market. Furthermore, the investors with the combined portfolio of diverse stock could eventually generate higher Returns from investment (Pedersen and Peskir 2017).
- Furthermore, investors using the minimum variance portfolio are able to tap into the diversification method, which substantially reduces the level of risk involved in investment. Therefore, minimum variance portfolio allows the investor to increase the diversification process to accommodate mode stocks which good yield high returns on yearly basis. However, the depicted in the above figure relatively represents the level of different risk and return attributes that can be generated from the efficient Frontier. Investors can use different combination of weeds represented by the efficient Frontier to increase the level of risk and return from their investment.
- Another significance of minimum variance portfolio is its compatibility to utilize different stocks to derive the adequate portfolio that could have the least risk involved in investment. This is a major significance for the investment technique, as it could combine different investment categories such as equity, bonds, and risk-free interest to derive the level of returns that could be generated from investment. Minimum variance portfolio allows investor to formulate an accurate investment scheme, which could help in securing the returns for long duration (Kuehin, Simutin and Wang 2017).
- Lastly, the minimum variance portfolio directly supports the conservative investors and secures their invested capital, which directly helps in reducing the level of risk involved in investment. The investors using the minimum variance portfolio are able to maximize the level of income, which can be generated from investment.Hence, it can be understood that with the use of minimum variance portfolio investors can conduct adequate investments to secure their invested capital.
Figure 4: Capital Asset Pricing Model
(Source: He, Kelly and Manela 2017)
The calculations depicted in the above figure represent the formula for Capital Asset pricing model, which has been used by maximum of the investors all around the globe to derive expected returns from any investment. The formula relatively represents the minimum level of requirements that needs to be fulfilled by the investor to derive the expected return of a particular investment scope. The use of market risk premium, risk free rate, and beta of the particular stock directly allows the investor to detect the expected returns of the investment. However, the measures for deriving the beta or risk factor are mainly contradictory for different investors. Therefore, it could be understood that Capital Asset pricing model has both significance and limitations, as it derives the expected returns of an investment. Squartini et al. (2017) mentioned that with the help of Capital Asset pricing model investors are able to derive the weighted average cost of capital of a particular stock, which is used as an adequate measure for making investment decision. Nevertheless, there were different measures that were introduced in comparison or as an alternative to the Capital Asset pricing model. The alternative models that were used instead of Capital Asset pricing model are multi beta model, market price based model, accounting information based model and arbitrage pricing models (Fama and French 2017).
The different measures that was used instead of Capital Asset pricing model relatively needs excessive calculations and research, which is not possible for small investors. Therefore, it could be understood that Capital Asset pricing model directly allows the investor to see the level of returns that it would generate from the investment in a particular stock. Capital Asset pricing model has a relevant significance and limitations, which are depicted as follows.
- The major disadvantage of the Capital Asset pricing model is it a combination of different assumption that need to be conducted by investors for deriving the expected returns of a particular stock. The investors need to evaluate the stocks beta, which is derived from different sources, while the detection of market returns and risk free rate is also essential. Therefore, it could be understood that the assumptions that is made by the Capital Asset pricing model directly reduces the level of efficiency of expected Returns derived from the calculation. Furthermore, Capital Asset pricing model only consists of a single factor method, which relatively does not allow the investor to comprehend the risk and return attribute of a particular stock (Finkel et al. 2017).
- There is also a significant advantage for the use of Capital Asset pricing model, as it allows the investor to understand the significant expected Returns of an investment. the calculations that is conducted in Capital Asset pricing model is a relatively simple and does not need statistical method to derive the overall output. This eventually helps the investor to minimize the exposure of calculation that can be conducted for a particular stock. Furthermore, small investors use Capital Asset pricing model, which does not have the capability to support statistical calculation in arriving at investment decision. Therefore, the CAPM method would eventually support the investor to detect the current valuation of a particular stock before conducting any kind of investment decision.
After evaluating the theories and techniques described in the above assessment, it could be identified that investors meet and accurate and reliable measure for detecting the level of risk and return attributes of an investment. These measures can be identified with the help of several techniques and theories such as Capital Asset pricing model, minimum variance portfolio, security market line, and capital mark. The use of the above theories and techniques is relatively based on the choice and consideration of the investors, as it allows small and large investors to make adequate investment decisions. Hence, the assessment highlights the significance of risk and return evaluation, which allows the investors to secure their exposure in the capital market.
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