Question

21.With the aid of a diagram, describe the capital market line (CML). Your answer should include reference to the importance of the slope of the CML. ‘If investors are rational they will all choose risky assets in the same proportion when riskless asset borrowing and lending is allowed’. Do you agree with this statement? Explain your answer.

24.With the aid of a diagram, describe the security market line (SML). Your answer should include reference to the importance of the slope of the SML. Explain the beta as a risk measure. What is the alpha of a stock?

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

CAL is a line which makes up the allocation between a risky portfolio and a risk free asset for an investor, and CML is a special case of CAL, where it reflects the expected return of a portfolio considering the all combinations of the market portfolio and a risk-free asset. The market portfolio is completely diversified, and has only systematic risk, and the expected return is equal to the expected return of the market. So the purpose of CML for investors is that they can combine the risky market portfolio and the risk-free asset portfolios as per there risk preferences to build a higher risk-return portfolio.

The slope of the CML is the sharpe ratio of the market portfolio. The intercept point of CML and efficient frontier is the efficient portfolio (aka tangency portfolio).

Sharpe ratio = /

Closer the Sharpe ratio to the slope of CML, the better the performance of the fund in terms of return against risk.

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As we know- Higher is the risk, higher is the return, and rational investor looks forward to invest in riskier assets for higher returns. This can be portrayed in the CML, for a portfolio to be considered as efficient (or Markowitz efficient) it should be reflected on the CML. The capital market line’s slope represents the equilibrium market price risk’s calculation. A risky asset with a well-diversified portfolio have zero unsystematic risks, so it has no standard deviation. so, if an investor is able to borrow or lend at the risk-free rate, then he or she can create an asset allocation with - Risk free assets and a portfolio of risky assets.

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The SML,security market line, displays the expected rate of return of a security as a function of systematic, non-diversifiable risk. in simple terms, The SML is a graphical representation of the Capital Asset Pricing Model CAPM and it plots the risk against the expected return of the entire market at a given point in time.It is derived from the Markowitz Portfolio Theory.The security market line is the theoretical line on which all capital investments lie. the graphs plots risk on its horizontal axis (independent variable) and expected return on the vertical axis (dependent variable).
The formula for the Security Market Line is:

Required Return = Risk Free Rate + ( Beta x [Market Return - Risk Free Rate])

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The slope of the Security Market Line is determined by market risk premium. Higher the market risk premium steeper the slope and vice-versa.

Beta is a measure of volatility or systematic risk or a security or a portfolio as compared to the market as a whole. The market can be considered as an indicative market index or a basket of universal assets.

If Beta = 1, then the stock has the same level of risk as the market. A higher beta i.e. greater than 1 represents a riskier asset than market and beta less than 1 represents risk less than the market.

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