Solved The only difference between the capital market line CML and the Principles of Finance FNCE10002

Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks. The SML and CML are both concepts related to one another, in that, they offer graphical representation of the level of return that securities offer for the risk incurred. Both CML and SML are important concepts in modern portfolio theory and are closely related to CAPM. There are a number of differences between the two; one of the major differences is in how risk is measured.

CAPM is a financial model which considers the cost of capital, average expected return on investment, and market risk in order to evaluate how much companies should borrow or invest. SMLs are mathematical models created by theoretical economists that help investors understand the behavior of markets. The capital allocation line makes up the allotment of risk-free assets and risky portfolios for an investor. The Capital Market Line (CML) is a graphical representation of the relationship between risk and return for an efficient portfolio of risky assets. CML is used to help investors determine the expected return and risk of an efficient portfolio that combines a risk-free asset with a portfolio of risky assets. It is line connected to Risk free Rate and Optimal Portfolio(Market portfolio in the figure).

Understanding Capital Market Line (CML) and How to Calculate It

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The tangency point is the optimal portfolio of dangerous property, known as the market portfolio. The capital market line represents portfolios that optimally combine threat and return. Capital asset pricing mannequin , depicts the trade-off between risk and return for environment friendly portfolios. The SML essentially graphs the results from the capital asset
pricing model (CAPM) formula.

Difference between SML and CML

It is a graphical representation that shows s a portfolio’s expected return based on a particular level of risk given. The CML is a line that is used to show the rates of return,
which depends on risk-free rates of return and levels of risk for a specific
portfolio. SML, which is also called a Characteristic Line, is a graphical
representation of the market’s risk and return at a given time. The equity risk premium (ERP) is often used interchangeably with the term “market risk premium” and is calculated by subtracting the risk free rate (rf) from the market return.

The Capital Market Line (CML) and Security Market Line (SML) are two important concepts in finance that are used to assess the risk and return of investment portfolios. While calculating the returns, the expected return of the
portfolio for CML is shown along the Y- axis. On the contrary, for SML, the
return difference between cml and sml of the securities is shown along the Y-axis. While the Capital Market Line graphs define efficient
portfolios, the Security Market Line graphs define both efficient and
non-efficient portfolios. While standard deviation is the measure of risk in CML, Beta
coefficient determines the risk factors of the SML.

Difference Between Capital Market Line (CML) and Security Market Line (SML)

The x-axis represents the risk (beta), and the
y-axis represents the expected return. The security market line is a useful tool in
determining whether an asset being considered for a portfolio offers a
reasonable expected return for risk. If the security’s risk versus expected return is plotted above the
SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting less return for the amount of risk assumed. It is important to note that all portfolios on the CML offer a superior risk-reward profile to any portfolio on the efficient frontier. This is evident when drawn out, since the CML is above or to the left of the efficient frontier at all points .

Capital Market Line is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets. Security Market Line measures the risk through beta, which helps to find the security’s risk contribution to the portfolio. The optimal portfolio of Stock A and Stock B has an expected return of 12% and a standard deviation of 25%. Using CML, the investor can plot the expected return and risk of the efficient portfolio as a point on the line connecting the risk-free rate of return to the optimal portfolio.

SML vs CAL – Differences

We aim to be a premium yet affordable prep provider for finance certification exams. The similarities between the CML and SML as models of the risk-return tradeoff are that both are a graphical representation of risk-return… Therefore, a security positioned above the SML should exhibit higher returns and lower risk, whereas a security positioned below the SML should expect lower returns in spite of the higher risk. PrepNuggets is a creator of CFA® program study materials to aid candidates who are looking for more concise materials for their exam preparation.

• Examples for risk free assets include treasury bills, bonds, and government issued securities, whereas risky assets can include shares, bonds, and any other security issued by a private organization.
• The security market line SML is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model CAPM.
• The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.
• However, many people feel suitable to refer to a higher level of risk so they can figure out what level of risks they should be taking.
• Discuss the similarities and differences between the CML and SML as models of the risk-return tradeoff.

In a well-functioning market/competitive market, a market portfolio is made up of all these assets, so, all the assets must plot on the SML. SML uses the beta coefficient to calculate the risk, which, in turn, assists in determining how much security contributes to the overall risk. In a broader sense, the SML shows the expected market returns at a given level of market risk for marketable security. The overall level of risk is measured by the beta of the security against the market level of risk. Security market line (SML) is the representation of the Capital
asset pricing model. It displays the expected rate of return of an individual
security as a function of systematic, non-diversifiable risk (its beta).

It very efficiently depicts the combined risk-free returns of all the portfolios. However, some people find it more convenient to refer to the CML for measuring the risk factors. CML shows the total risk and measures it in terms of the SML (beta or systematic risk).