Question

Explain why using the Security Market Line (SML) to select securities is inconsistent with a strict application of the Capital Asset Pricing Model (CAPM).

Answer 1

Using security market line to select securities is inconsistent with strict application of Capital Asset pricing model due to assumptions which are not consistent with the practical world like-

(A)Capital Asset pricing model is assuming that there are no transaction cost in this world so it is a complete contradictory assumption because in actual world there are transaction costs involved.

(B)Capital Asset pricing model is also assuming that there are no taxes in this world and it is a tax free world but it is not in reality, there are taxes and Taxes are a major component in selection of securities.

(C) Capital Asset pricing model assumes that markets are in equilibrium and there are no inflation but in actual world markets are not in equilibrium and there are inflation involved to a large extent.

(D)Capital Asset pricing model is also just using beta in order to determine the risk associated with investment but there are other market risk also involved which are more factors than just beta so they will have to be comprised in the systematic risk in order to evaluate a security.

it is to be known that security market line is representing the Capital Asset pricing model and securities which are lying below or above the security market line, are used as measure for investment, so this assumption about tax free world and no inflation and only beta as a systematic risk is completely inconsistent in the practical world, because in practical world, these are major factors for deciding upon investment into securities.