Question

27.With the aid of diagrams, compare and contrast the

(i) capital market line and

(ii) security market line. Your answer should includereference to the importance of the slopes of the respective lines.

28.With the aid of a diagram, explain the terms of ‘defensive stocks’, ‘neutral stocks’ and ‘aggressive stocks’.

Answer 1

27. i) Capital Market Line (CML)

CML is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return (Rf) and the market portfolio of risky assets (S).The market portfolio is the point (S) where the CML is tangential to the Efficient Frontier.

Under CAPM, all investors will choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given level of risk.

The slope of the CML is the sharpe ratio of the market portfolio. As a generalization, buy assets if the sharpe ratio is above the CML and sell if the sharpe ratio is below the CML.

ii) SECURITY MARKET LINE (SML)

The security market line (SML) is a graphical representation of the capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of various marketable securities, plotted against the expected return of the entire market at any given time. Also known as the "characteristic line," the SML is a visualization of the CAPM, where the x-axis of the chart represents systemic risk (in terms of beta), and the y-axis of the chart represents expected return.

CAPITAL ASSET PRICING MODEL Equation :-

COMPARISON :

	Security market line (SML)	Capital Market Line (CML)
Definition	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	CML is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return (Rf) and the market portfolio of risky assets (S)
Measure of Risk	The SML uses systematic (non-diversifiable) risk	The CML uses standard deviation (total risk)
Significance	SML is a graph of Capital Asset Pricing Model (CAPM)	CML is a graph of Efficient Frontiers
Use	SML is a tool used to determine the appropriate expected returns for individual securities	CML is a tool used to determine the appropriate asset allocation (% allocated to market portfolio and risk-free asset) for the investor
Slope	The slope of the SML represents the Market Risk Premium	The slope of CML represents the Sharpe Ratio of Market Portfolio

28.

Defensive Stocks - Stocks which have beta<1, indicating lesser systematic risk than the market, are called defensive stocks. Defensive stocks tend to be more stable during the various phases of the business cycle. Typically, Utility, Consumer staples & Healthcare stocks are considered as defensive stocks.

Neutral Stocks - Stocks which have beta=1, indicating same systematic risk as the market, are called neutral stocks.

Aggressive Stocks - Stocks which have beta>1, indicating more systematic risk than the market, are called defensive stocks. Consumer discretionary, financial services sector stocks are considered Aggressive stocks.