Question

Explain the Capital Market Line, the Security Market Line and the difference between the
two.

Answer 1

Capital market line:

Capital market line is a represantation of optomal distribution of risk and return of a portfolio. CML shows the rates of return for a specific portfolio. A Capital allocation line (CAL) is the distribution of risk-free assets and risky portfolio. Capital market line is a perticular state of the Capital allocation line, where the risk portfolio is same as the market portfolio. Hence, the slope of the CML is the sharpe ratio of the market portfolio. As a indication, assets should be bought when the sharpe ratio is situated above the CML and assets should be sold when the sharpe ratio is situated below the CML. In CML risk is measured by standard deviation.

The equation of CML is gives below:

Security market line:

Security market line or SML is often used by fund managers and investors to find out the value of an financial asset before including to their portfolio. Security market line is a graphical representation of capital asset pricing model (CAPM). It is a good tool for comparing value of two stocks with similar return. Unlike CML, it represents the risk and return of market at a given time. SML helps to determine the expected returns of individual assets. In SML risk is measured by systemetic risk or BETA.

The equation of SML is gives below:

Where,

R = Required Return

Risk free ROR = Risk-Free Rate of Return

Beta = Market Return - Risk-Free Rate of Return

Difference between capital market line and security market line:

The risk in capital market line is the total risk, which is measured by standard deviation. But in case of security market line, the systematic risk is considered, which is measured by BETA.

The CML is used to determine the rates of return, which depends on risk-free ROR & the level of risk for a perticular portfolio. Where, SML is a graphical representation of the risk and return of the market at a given period of time.

The CML can define efficient portfolios only, but the SML can define not only the efficient portfolios but non-efficient portfolios also.