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

Graphical and Conceptual Differences between SML and CML

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.

CML is the abbreviated version of Capital Market Line and SML stands for Security Market Line. Both these lines are basically the graphical representation of the Capital Asset Pricing Model (CAPM). The capital market theory reveals a crucial step towards how stakeholders should ponder over their investment procedures. Further to this, it is the CAPM which furthers down the capital market theory in a manner which permits investors to examine the risk-return trade-off for both diversified portfolios as well as single securities. It is the CAPM which utilises the SML and CML. However both of these lines are very different both graphically as well as conceptually. The under mentioned paragraph would enable detailing about the difference between the SML and CML.

The CML is the line that reveals the rate of returns, that is dependent upon rates of return which is free from all risks and levels of risk for a particular portfolio. Whereas SML which is also connoted as Characteristic Line, is a graphical presentation of the risk which is prevalent in the market and the return at a particular time. Another difference between the two terms is the methodology of measuring risk factors. CML measures the risk factor by the method of standard deviation or via the total risk factor whereas the SML measures the risk factor with the help of Beta Coefficient which enables to search the security’s peril involvement to the portfolio. The third dissimilarity between the two is that the Capital Market Line’s graph defines which portfolios are performing well and competent by nature whereas the Security market Line graph determines both competent as well as non-competent portfolios (Lee & SU., 2014). CML is a narrowed terminology as it establishes only market portfolio and those assets which are free from any kind of risks, whereas on the contrary SML enables determination of all the security variables and factors. In contrast to the Capital Market Line, the Security Market Line reveals the anticipated returns of the single assets. Thereby it can be construed that while CML shows the risk and return for the portfolios which yield good results and are competent by nature, the SML establishes the risk or return for each and every stock or asset separately (differencebetween.net., 2016). However, as compared to the Security Market Line with the Capital Market Line, the latter is construed to be superior when measuring the risk variables.

Methodologies Used to Measure Risk

Source: https://financialmanagementpro.com/capital-market-line-cml/

In the said CML graph, two portfolios are assumed:

1. Lending (non-leveraged) Portfolio A with a standard deviation 5%
2. Borrowing (Leveraged) Portfolio B with standard deviation 15% (Smirnov., 2016)

Source: https://thismatter.com/money/investments/capital-asset-pricing-model.htm

In the above SML graph , it is presumed that a market return of 12% and a risk free rate of 4%.

Thus Y axis of the Capital Market Line shows the expected return and the X axis shows the standard deviation and the Y axis of Security Market Line shows the level of return that is needed on the individual assets and the X axis reveals the level of risk represented by Beta.

Minimum Variance Portfolio  (MVP) is a portfolio structuring model which may apparently seem to be complicated but the same can enable maximise returns and reduce the risk considerably, which is the main aim of all the investors across the globe. If one can formulate and develop a minimum variance portfolio successfully, the investor can gain the best possible result with minimum risk. Therefore it can be said that it’s a type of a “have your cake and eat it too” tactics in the investment globe (Thune, 2017).

Before its importance is discussed it is very crucial to know what it is actually. The minimum variance portfolio is a portfolio of stocks and securities that come together to reduce the price instability of the entire portfolio. Volatility which a more commonly used word than variance in the investment world, is basically a statistical measurement of a specific stock’s price movement i.e. its ups and downs. Further to this, the instability of a security is also exchangeable in line with the risk in the market. Thus more the volatility of a particular stock or portfolio, the higher the market risk and vice-versa. Therefore it can be said that MVP is a spread of investments with the least amount of volatilities i.e. those securities which have lowest chances of fluctuate with regards price as they have the least amount of sensitivity towards risk. Investors who are not wanting and desirous to undertake higher risks should take into account the minimum variance portfolio. The concept is explained int he below graph

As is understood that the minimum variance portfolio is at the turn of the curve, where variance (price fluctuation likelihood) is at its minimum.

The Minimum Variance Portfolio is considered to be very crucial and important due to various features it offers to the investors which helps them form a portfolio with minimum risk. The MVPs generally ensure to robustly surpass and perform better than expected market cap, weighted portfolios and at the same time ensures to minimise the risk for the long term future. The MVP basically does not support the Capital Asset Pricing Model which states that more risk means more returns. The market cap weighted portfolios consider certain risks which are branched out and is not supported by any kind of risk premium (Market Business News., 2016). Thus in the theoretical parlance, MVPs do not consider these risks, hence gains advantage via these lesser risky portfolios and at the same time not compromising on the return. But this single handed does not clarify the fact of outperformance.

Importance of Minimum Variance Portfolio

The main purpose of MVPs is to reduce the level of risk associated with the securities which form a part of the portfolio, hence they will be inclined towards those securities and assets which are not too volatile by nature, and move away from those assets which are highly volatile by nature. Thus MVPs pick those assets only which are underpriced. As and when the said underpricing gets minimised and the variables start moving towards volatility and interrelated to other assets, their weightage is minimised in the MVP and may even be gradually removed totally, and by the application of the said procedure, MVP helps to achieve better than expected performance (Thune, 2017). Thus it is best for those investors who are risk averse.

The importance of Minimum Variance can be understood from the view point of an investor who is more apprehensive by the chances of any kind of major losses or reduction in the portfolio value and hence with the entire volatility of their equity portfolio, they may be interested in taking up such portfolios which have lesser volatility issues but at the same time are inclined towards continuing a totally unprejudiced coverage to the appropriate equity yardstick. The Minimum Variance approach has come to the highlight recently due to the prologue of various indexes. In contradiction to the squat instability approach as discussed above, the main motive of the MVP is to form such a portfolio which would comprise of securities with, the on the whole, lowest instability, question to definite constrictions. Thus the main reason why investors are inclined towards a Minimum Variance Portfolio is simply because the risks are low yet the returns are outstanding (FTSE Russel, 2015).

The Capital Asset Pricing Model (CAPM) was developed in 1952 by Harry Markowitz and was gradually adopted by other economists and investors such as William Sharpe. It enables developing the linkage between the risk that an investor is exposed to and the expected rate of return. As per the CAPM model and the equation it states, the required rate of return of a specific security or asset or portfolio is equal to the addition of the rate on a risk-free security and risk premium (moneystock.net., 2009).

The CAPM equation is considered to be more apt in comparison to the other equations while computing the required rate of return due to varying reasons. The Weighted Average Cost of Capital (WACC) can be used as the discount rate in the investment appraisal on the presumption that a certain number of restrictive assumptions are met. The assumption basically discusses that WACC can be applied as a discount rate only if the investment project or portfolio stays intact without any kind of alterations such as business risk or financial risk. If the business risk of the investment portfolio alters and is dissimilar to that of the investing entity, then CAPM can be the best method to be used to compute the project particular discount rate. Thus using of CAPM would be more apt than WACC in the twin shaded area which can be understood by taking two projects A and B. The project A would be rebuffed if WACC was taken as the discount rate, since the internal rate of return (IRR) of the project is lower than that of WACC. The said investment decision is construed to be wrong. But if the CAPM was applied, then the project would have been accepted since the project IRR lies above SML. The returns given by the project is much more than that required balancing for its range of systematic risk and thereby by accepting it will ensure to enhance the wealth of the shareholders. Further if WACC was applied to project B then it would have been accepted since the IRR is more than the WACC discount rate. But if CAPM was applied then the said project would have been rejected since IRR of the project connotes inadequate remuneration for its range of systematic risk.

Relevance of CAPM Equation

There are various benefits offered by CAPM over the other methods of computing the rate of return which clarifies why it is still accepted universally after four decades. CAPM takes into consideration only systematic risk, which exhibits a truth in which most of the investors have diversified portfolios which has ensured to eradicate the unsystematic risk. It produces a theoretically derived linkage amongst the required return and the systematic risk which has been questioned to continuous pragmatic study and trying. Further to this, the CAPM is most of the time viewed as a much better way of computing the cost of equity rather than the dividend growth model, wherein it unambiguously and clearly takes into account a corporates’ level of systematic risk qualified to the stock market on the whole. Lastly, it is also better than the WACC as discussed above in providing the discount rates for the purpose of investment evaluation. Therefore, it is understood that studies have been conducted to criticise the said model but CAPM has always been able to prove itself superior to all other equations for computing the required rate of return (accaglobal.com. 2016).

On analysing the essay structure, it is understood that the Capital Asset Pricing Model is the most widely used model for the computation of the required rate of return of an investment portfolio. Various newer models have come up, but the accuracy provided by this model is still not been broken by any of them. Although ideally every risk averse investor would be inclined towards a MVP yet the computation of the same whether efficient or not would be best done under the CAPM as it considers all the relevant factors within certain constraint assumptions.

References

Accaglobal.com., (2016), CAPM: Theory, Advantages and Disadvantages, Available at https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html (Accessed on 16th May 2018)

Differencebetween.net., (2016), Difference Between CML and SML, Available at https://www.differencebetween.net/business/difference-between-cml-and-sml/ (Accessed on 16^th May 2018)

FTSE Russell, (2015), Low Volatility or Minimum Variance. Available at https://www.ftse.com/products/downloads/Low-Vol-Whitepaper.pdf (Accessed on 16th May 2018)

Lee,M.C., & Su, L.E., (2014). Capital Market Line Based on Efficient Frontier of Portfolio with Borrowing and Lending Rate. Universal Journal of Accounting and Finance. Vol.2. no.4. pp. 69-76

Moneystock.net., (2009), Capital Asset Pricing Model, Available at https://www.moneystock.net/wp_e/2009/09/08/capital-asset-pricing-modelcapm/ (Accessed on 16^th May 2018)

Market Business News., (2016), What is a minimum-variance portfolio? Available at https://marketbusinessnews.com/financial-glossary/minimum-variance-portfolio/ (Accessed on 16^th May 2018)

Smirnov,Y., (2016), Capital Market Line – CML, Available at https://financialmanagementpro.com/capital-market-line-cml/ (Accessed on 16^th May 2018)

Thune,K., (2017), What is a Minimum Variance Portfolio (and How it Helps to Diversify) Available at https://www.thebalance.com/minimum-variance-portfolio-overview-4155796 (Accessed on 16th May 2018)