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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.

Corporate Finance

Corporate finance is the part of the finance which deals with the capital structure and various sources of funds through which the capital is raised by the business. The actions in the corporate finance are taken by the managers in order to manage the value of the company among the shareholders. In the report, the security market line, capital market line, minimum variance portfolio and capital asset pricing model. It measures that how these tools help the business to reach over conclusion about the performance of the business (Zabarankin, Pavlikov and Uryasev, 2014). The main objat9ives of the report is to identify the different tools of corporate finance and use them in proper way to improve the performance of the investment and other factors of the business.

Security market line i.e. SML represents the capital assets pricing model (CAPM) equation in a graphical manner. It shown the risk and return on both the axis to reach over a conclusion about the investment in a business. The systemic risk of the business is calculated in the SML to identify the return level from that particular security. It describes that at what evil of risk, how much return of the business would be. Generally, the more the associated risk of an investment would be, the more the return from that stock would be.  It also represent in its graph about the opportunity cost of the investment. Below is the graphical representation of security market line (Lumby and Jones, 2007).

Beta

Security Market Line: ri

Risk-Free Rate

0.00

6.0%

6%

0.50

8.5%

6%

1.00

11.0%

6%

1.50

13.5%

6%

2.00

16.0%

6%

Figure 1: Security Market Line

(Zabarankin, Pavlikov and Uryasev, 2014)

Consequently, the capital market line (CML) is a graphical line which represents about the rate of return of a specific and efficient portfolio of few assets. The capital market line is represented the different risk level of the business which is chosen by the investors on the basis of the nature of the investment and the expectations form the investment. The capital market lines improve the return on the basis of the given risk of the portfolio. While, if the SML line is taken into the concern than it is just a graphical representation of CAPM model. The graphical representation of CAPM and SML are as follows:

Figure 2: CML and SML

(Ross, Westerfield, Jaffe  and Kakani, 2008)

The above given diagram of CML and SML represent that the SML graph has been prepared on the basis of the CAPM factors only which includes the risk and return level while in case of CML line, a trade off has been seen among the associated risk of the portfolio and total rate of return. The main difference among both the graphs is the method of measuring the risk factors of the portfolio. The capital market line takes the concern of the standards deviation in order to measure the associated risk of the business (Moles, Parrino and Kidwekk, 2011). On the other hand, SML mainly focuses on the beta factor of the security to identify the associated risk. The above graph represent that either efficient or none efficient portfolios could be presented in the SML while in case of CML, only efficient portfolios could be represented in the graphical manner.

Security Market Line (SML)

In context of calculating the return in both the lines, it has been found that both of the graphs are representing the expected return at Y axis and the risk factor of the graphs are shown on the X axis. In case of SML, the risk factor is beta and in case of CML, the risk factors if CML. The nature of CML and SML could be studied thoroughly on the basis of their formulas which are given below:

Security market line = Risk Free Rate of Return (RF) + Beta * (Market Return – Risk Free Rate of Return)

If the above given graphs of CML and SML is taken into the context than it has been found that the SML graph represent about the beta and the expected return of a particular security. It offers the risk return trade and their volatility in the scrutiny market of the business. Market portfolio and risk free rate are majorly calculated in the business and the investment market on the basis of the CML. While all the other factors which could affect the investment and return form a particular security is calculated on the basis of SML. The CML measures risk and return of efficient portfolio in the business. Lee and Lee, (2006) has depicted into his study that CML is one of the best method to measure the risk factor of investment. Though, the SML line makes it sure that all the security and risk factors are considered.  

The overall evaluation express about huge difference among both the lines. Different outcome is get by both of the graphs and thus a manager is required to make sure the nature of the investment and must choose the method accordingly.

Minimum variance portfolio is the combination of various assets which are combined together and a weight is given to each of the asset on the basis of their associated risk and return to make a portfolio here the return from the investment would be higher. The investment into the portfolio (minim variance portfolio) is less risky than the investment into the individual securities. This process takes the concern of all the assets, their associated risk and return and assigns different weight to each of the security in order to lower the risk of the investment. The associated risk of the mini variance portfolio is always lowest than the investment into the individual securities (Mazzola and Gerace, 2015). The process does not depend on the return from the portfolio; the main motto of the process is to reduce the associated risk level of the business.

MVP does not show its concern bout the single securities which associates the lower risk. However, it takes the bunch of various stocks and assigns the different weight to them to reduce the overall risk of the investment. The MVP process goes through various steps in which the assets are chosen by the business firstly. Further, the risk, covariance, correlation, return etc of the securities have been calculated in order to give a proper weight to each of the asset. After measuring the risk and return of each of the assets of the investment, the weight is given in order to reduce the overall associated risk of the portfolio (Ross, Westerfield and Jaffe, 2007).

Capital Market Line (CML)

Different analyst has different through bout the minimum variance portfolio. Some of them feel that it is one of the best processes to reduce the overall risk from the investment. However, other feels that it takes the concern on various assumptions and unrelated factors which has affected the overall outcome of the process and lead to the analyst towards a bad outcome.

Figure 3: Minimum variance portfolio

The minimum variance portfolio could also be understood through the below given process:

Minimum variance portfolio

Exp ret

Std dev

Cor(1,2)

Cor(1,3)

Cor(2,3)

Stock 1

0.06

0.15

0.30

0.35

0.38

Stock 2

0.05

0.20

Stock 3

0.08

0.25

Risk free

0.12

Covariance matrix

0.0225

0.0090

0.0131

0.0090

0.0400

0.0190

0.0131

0.0190

0.0625

Minimum variance portfolio

Weight 1

0.657

Weight 2

0.273

Weight 3

0.070

Exp ret

0.059

Std dev

0.135

The above table express that the expected return and standard deviation of each of the company was different and a minimum variance portfolio has been done on all the three stocks in order to reduce the overall associated cost from the business. The return, risk, covariance and correlation of each of the security have been calculated and further the different weight has been given to the different stocks in order to improve the performance and reduce the risk of the investment (Lumby and Jones, 2007).

On the basis of the above table, it has been found that earlier the associated risk of stock 1. Stock 2 and stock 3 were 0.15, 0.20 and 0.25 as well as the return of all the three stocks were 0.06, 0.05 and 0.08 respectively. After applying the process of minimum variance portfolio, it has been found that the expected return of the investment has been 0.059 while the risk of the portfolio has been 0.135.

It expresses that the associates risk level of the investment has been lowered. However, the return factors have been ignored in the process. The importance of the process has been studied further which has been given as below:

  • The process makes it easier for the investors and the financial analyst to make decision about the investment.
  • It reduces the fluctuations in the total risk of the portfolio.
  • The risk level is the main focus of the process which is lowered than any individual stock.
  • This is one of the advanced processes which take the concern on all the related factors of the business (Ross, Westerfield, Jaffe  and Kakani, 2008).
  • The process is useful for the investors to make decision.

Through studying the minimum variance portfolio process, it has been found that the process is one of the significant approaches for the business to improve the performance and reach over a conclusion about the investment.

CAPM is a model which is used by the investors and the financial analyst to identify the expected return from the individual stock or a portfolio. It majorly takes the concern on the risk free rate, market risk premium and beta of the company to evaluate that how much return could be offered by the company to the shareholders, the CAPM represent the data in a graphical manner with the help of SML (Anwar and Kumar, 2018). It always focuses on the real figures to reach overall conclusion about the return of the stock and portfolio.

This fundamental tool also describe about the intrinsic value of the business on the basis of that it could be identified that whether the stock of the company are undervalued or overvalued. It identified the historical stock price of the business and identified the fluctuations in the stock price (Bao, Diks and Li, 2018). On the basis of that, beta factor of the company is measured and the other factors are taken on the basis of the country performance and the economical level. The CAPM equation of the company is as follows:

Minimum Variance Portfolios

r = kRF + b(kM - kRF)

Where,

r = required return

kRF = the risk-free rate

kM = the average market return

b = the beta coefficient of the security

(Campbell, Giglio, Polk and Turley, 2018)

the equation explain that how the risk free rate, market risk premium and the beta of the stock helps the investors and the analyst to identify the total return from the stock. The explanation of each of the item is as follows:

Beta is the main factor of the stock which represent about the total volatility in the stock price of the business. It is calculated through comparing the stock price of the company along with the index stock price (Xiao, Faff, Gharghori and Min, 2017). The higher beta of a company explains that the stock price and index price are not connected.

Market risk premium:

Market risk premium is the deduction of risk free rate from the market premium. It explains about the expected return from the risky stocks. It defines about the overall market position.

Risk free rate is the bond rate of Australian government treasury It is the minimum return which is expected by the investors from the stock.

For instance, below is an example of CAPM:

Stock Name

Calculation of cost of equity (CAPM)

Risk free rate

2.00%

RM (market return)

5.75%

Beta

0.770

Required rate of return

4.89%

(Damodaran, 2011)

Conclusion:

Through evaluation on various factors of the business, it has been found that the security market line, capital market line, minimum variance portfolio and capital asset pricing etc tools help the business to reach over conclusion about the performance of the business. The main objectives of these tools is to identify the different way to improve the performance of the investment and other factors of the business.

References:

Anwar, M. and Kumar, S., (2018) Sectoral Robustness of Asset Pricing Models: Evidence from the Indian Capital Market. Indian Journal of Commerce and Management Studies, 9(2), pp.42-50.

Bao, T., Diks, C. and Li, H., (2018) A generalized CAPM model with asymmetric power distributed errors with an application to portfolio construction. Economic Modelling, 68, pp.611-621.

Campbell, J.Y., Giglio, S., Polk, C. and Turley, R., (2018) Anintertemporal CAPM with stochastic volatility. Journal of Financial Economics, 128(2), pp.207-233.

Damodaran, A, 2011, Applied corporate finance. 3rd edition, John Wiley & sons, USA.

Lee.C.F and Lee, A, C,.2006. Encyclopedia of finance. Springer science, new York.

Lumby,S and Jones,C,.2007, Corporate finance theory & practice, 7th edition, Thomson, London.

Mazzola, P. and Gerace, D., (2015). A comparison between a dynamic and static approach to asset management using CAPM models on the Australian securities market. Australasian Accounting, Business and Finance Journal, 9(2), pp.43-58.

Moles, P. Parrino, R and Kidwekk, D,.2011. Corporate finance. European edition, John Wiley &sons, United Kingdom.

Ross, A,. Westerfield, R,W,. Jaffe,J,.and Kakani,R,K,.2008. Corporate Finance. 8th edition, Tata McGraw hill education private limited, New Delhi, India

Ross, S, A,. Westerfield, R, W,. And Jaffe, J,.2007. Corporate Finance. the McGraw-hill, India

Xiao, Y., Faff, R., Gharghori, P. and Min, B.K., (2017) The Financial Performance of Socially Responsible Investments: Insights from the Intertemporal CAPM. Journal of Business Ethics, 146(2), pp.353-364.

Zabarankin, M., Pavlikov, K. and Uryasev, S. 2014. "Capital Asset Pricing Model with drawdown measure", European Journal of Operational Research, 234 (2), pp. 508.

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