Question

a) DEFINE WHAT IS MEANT BY THE CAPITAL MARKET LINE (CML),                      
USING BOTH THE DEFINITION AND THE SHORT E(rp ) EQUATION.                      
                      
b) DEFINE WHAT IS MEANT BY THE SECURITY MARKET LINE (SML),                      
AND PROVIDE THE GENERAL EQUATION FOR THE SECURITY MARKET                      
LINE.                      

Answer 1

a) Capital Market Line (CML) - The line which connects the risk-free rate of return with the tangency point on the efficient frontier of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return is known as Capital Market Line (CML). The portfolios which have the best trade-off between expected returns and variance (risk) lie on this line. The tangency point also known as the market portfolio is the optimum portfolio of risky assets.

The capital market line equation can be written as follows.

E(Rc) = RF + SDc	E(RM) - RF
	SDM

where, SD_C is a standard deviation of portfolio C return, SD_M is a standard deviation of a market return.

b) Security Market Line (SML) - The market’s risk and return at a given time is known as Security Market Line (SML). It also shows the expected returns of individual assets and as compared to CML, the risk measured in the SML is the systematic risk or beta. The fairly priced securities are plotted on CML or SML and securities generating higher returns are plotted above whereas securities generating lower returns are plotted below CML or SML.

The security market line is based on the following CAPM equation

E(R_i) = R_F + β_i × (E(R_M) - R_F)

                             

where E(R_i) is an expected return of a security, R_F is a risk-free rate, β_i is a security’s beta coefficient, and E(R_M) is an expected market return.