The Capital Market Line and its Differences from the Security Market Line
The capital marketplace is a connect that depicts the rates of return. These rates of return are influenced by the ranks of peril for a precise collection as well as the risk-free rates of return. Security market line is thus defined as a distinctive route which is simply a graphical illustration of market’s peril and return at a certain time. Therefore this paper will critically explain on the variances between Capital market line and Security market line. Additionally, there is the presentation of the benefits of the minimum variance portfolios while showing why CAPM reckoning might be more vulnerable as compared to other reckonings with regards to the required rate of return (Ahmed & Zlate, 2014).
It’s quite clear that Capital market Line graphs depict the competent collections the Safety market track graphs show mutually competent and incompetent collections. The collection for Capital Market Line is exposed laterally on the Y- axis when yields are manipulated. In this case, it is divergent for Security Market Line. This manipulation also leads to the reappearance of the securities which are lateral on the Y-axis. Collection deviance is observed on the X-axis for Capital Market Line. The Beta of safety is displayed laterally on the X-axis for Security Market Line (Khan et, 2011).
The determination of the market collection and hazard free properties by the Capital Market Line is a matter of safety which is dogged by the Safety Market Line.
The Security Market Line and the Capital Market Line show the potential yields as indicated by the properties of individuals. As such, the Capital Market Line displays reoccurrence for the definitively competent collections. On the other hand, the Security Market Line is a validation of the reoccurrence for the stocks that belong to individuals. It can be concluded that the Capital Market Line is the best means for risk issues determination (Anbar & Alper, 2011).
The market portfolio that is expected is 12.5%. The expected return of B is 27.5%.
E(RA) = 5+1.5*5=12.5%
E(RB) =5+1.5*15=27.5%
Limitation usage
- Taxes and costs transaction are plenty and these differ significantly based on the investors.
- Investors generally can borrow or lend unlimited amount at risk-free rate. In the market conditions on the ground investors can lend at substantially lower rates than when borrowing. This brings a bend of CML. A strong form of efficiency is not evident in real markets. This means that investors have unequal access to information.
- A strong form of efficiency is evident in the real markets. This means that investors have unequal access to information.
- Investors are not necessarily fully rational and risk-averse.
- The real markets are impacted by risks of inflation, currency and reinvestment risk. Standard deviation is one of the risk measurements that are utilized. .
- Risk-free assets are generally not available.
The end result is a representation of CML in real market is in form of a fuzzy area (Huarng & Yu, 2006).
The security market line is vital in determination of whether assets can be considered for a portfolio. This offers a basis for the return for risk. Individual securities are indicated on the SML graph. The plotting of security risk against the expected return above the SML indicates undervaluing as the investor gets to expect a larger return for the risk which is inherent. A security below the SML shows overvalue. This is because the investor may be willing to accept a lesser return for the amount of risk that is assumed (Maringer, 2006). The values expected for the SML can be calculated with the following equation:
|
Es = rf + Bs(Emkt – rf) |
Benefits of Minimum Variance Portfolios and Vulnerabilities of CAPM Calculations
The sensitive part of the investment to the portfolio is the beta. In isolation, a project can be considered riskier than the risk situation profile of a company. The risk profile can be accounted for through use of SML in calculation of the WCCC of a company (Vafeas et al, 2008).
Example:
When a new product line for Newco is considered, the project’s beta is 1.5. Assuming the risk-free rate is 4% and the expected return on the market is 12%, compute the cost of equity for the new product line.
Answer:
Cost of equity = rf + Bs(Emkt – rf) = 4% + 1.5(12% – 4%) = 16%
The project’s required return on retained earnings is therefore 16%, a number which should be used in our calculation of weighted average cost of capital (WACC) (Yang et al, 2003).
The x-axis of the Security Market Line diagram is defined by the beta while the y-axis is defined by the probable return. The risk-free rate worth is the beginning of the track (Megginson & Netter, 2007).
- The sanctuary market streak gradient is computed by market risk premium (RPM). This is modified in between the reoccurrence in the probable market and the risk-free rate. When the market risk premium is great the gradient and the lesser market risk premium show a gentler slope.
- The Security Market Line is not rigid. This can amend the slope and y-axis intersection over time. It is influenced by changes in interest rates, risk-return trade-off.
- The beta coefficient of a specific security changes from period to period. The position of the coefficient on the line also changes.
The change of Security Market Line may also occur when a core economical factor of change is observed in the anticipated inflation rate, rate of employment and gross domestic product (Hermes et al, 2011).
The security market line has the similar limitations as CAPM because it is based on the same assumptions. Real markets conditions can’t be characterized by strong efficacy because market participants have different abilities to borrow money at a risk-free rate, and transaction costs are different. The CAPM model offers a theoretical look into how financial markets price
stocks which allows investors to gauge expected returns. Stock returns are a function of dividends plus capital gains, divided by the price at which the asset was bought (Henriques & Sadorsky, 2008). The CAPM model being one of the central focus areas of modern portfolio theory, has a number of applications in the investment universe including estimating the cost of equity capital. The standard CAPM equation is:
Expected return= RF + Beta (RM – RF)
Where;
RF = the risk-free rate of return
Beta = the investment’s beta value
RM = Expected return from the market
The risk-free rate of return is often represented by the safe government bonds since these have little risk of default and interest payments are regular and easily predicted (Al-Malkawi et, 2010).
The second part of the equation is a quantification of an investment’s risk premium and helps determine how the compensation for the demand of investors when buying into the inherent risk of the asset. The sensitivity of the fund to the movements of the market is multiplied by the surplus return expected from the market. When markets gain high volatility, the stock with beta amounting to more than one will experience much greater volatility than the market involved. This can bring about high returns while experiencing the volatility. A limitation of the CAPM model is the application of the systematic risk instead of the idiosyncratic risk. This is due to the diversification of assumptions and efficiency of markets (Hashemijoo et al, 2012).
Security Market Line and Determining Assets for a Portfolio
Another limitation of CAPM is the ability to give accurate analysis of the expected market returns. Market returns are in many cases predicted by the assumption that the market’s risk premium will maintain its line with long term averages. On the basis of assumptions the expected return from the market portfolio developed may be computed by addition of the market risk premium to the risk-free rate (Bollerslev, 2008).
The basic CAPM model may also be expanded to comprise other factors into account. This provides a more complex forecast of expected returns. There are a number of CAPM variations which have been established in the recent past. There are several other financial models which utilize CAPM in calculation of the risk-return ratios. On the other hand, CAPM equation is crucial in reaching the expected asset return as the returns. This is from a risk free investment with the addition of risk premium. This is multiplied by the beta value of the investment. The capital asset pricing model is financial tool that is vital for investors to determine the price of an investment. This is based on the expected return metrics and its risk.
Despite the limitations CAPM also displays significant advantages. This include the following;-
- Ease-of-use: CAPM can be tested to achieve a range of potential outcomes which provide confidence as concerns the relevant rates of return.
- Portfolio is varied: The investors have a diversified portfolio which differ from the market portfolio. This subsequently lowers unsystematic risk.
- Systematic Risk (beta): CAPM accounts for the systematic risk. This is left out of other return models. Case in point, the dividend discount model (DDM). Systematic or market risk is a critical variable as it is not foreseen. This, in many situations, cannot be fully mitigated. The prime reason is that it is often not fully expected.
Minimum variance portfolio refers to security portfolios which combine to lessen the price volatility of the overall portfolio. Volatility in the community of investment is a measure of a specific price movement security. Hence, the greater the volatility of a particular investment the higher the market risk (Naceur et al, 2006).
Conclusion
In conclusion, we can evidently say that capital market line model is the best model to adopt since it’s said to measure risks in an ultimate manner. Minimum variance portfolios are well is prioritized since variance portfolio is a portfolio of securities that combine to minimize the price volatility of the overall portfolio. Whereas, CAPM equation is considered since CAPM equation quantifies expected asset return as the returns from a risk free investment plus the risk premium multiplied by the investment’s beta value.
I would propose that companies to uphold Capital Market Line method in determination of rates of returns since it’s the best compared to Security Market Line method which is seen to be best in determining risk issues
Would also propose that capital asset pricing model being a financial tool which helps investors to determine the price of an investment, based on its risk and expected return metrics to be upheld too by investors and companies.
Limitations of the Security Market Line and the CAPM Model
The CAPM model also, having a theoretical look into how financial markets price
stocks it allows investors to gauge expected returns. Stock returns should thus be considered to be a function of dividends plus capital gains, divided by the price at which the asset was bought.
Volatility in the investment should also be highly taken in consideration since it’s a statistical measure of particular security’s price movement and thus, the greater the volatility of an investment the higher the market risk.
References
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