The Significance of Security Market Line and Capital Market Line
The overall assessment aims in identifying the significance of SML and CML line, which could allow investor to maximise their profitability. In addition, the discussion on the significance of minimum portfolio variance is also conducted, which is used by investor to maximise their profits and minimise risk from investment. In addition, the assessment aims in detecting the significance to CAPM formula in deriving the required rate of return in comparison to other formulas used by investors. This detection of the formula would eventually help the investors to improve their return generation capacity while reducing any kind of risk that might incur in their Investments.
Figure 1: Diagram of SML (Security Market Line) and CML (Capital Market Line)
(Source: Sharpe 2017)
The above figure mainly helps in identifying the overall difference between security market line and capital market line which relatively provide the investors with adequate insights of their investment scope. the function of capital market line and security market line is the relatively same, as it allows investors to gauge into the level of risk and return provided from their investment. However, the difference of capital market line and security market line is relatively immense, which characterizes the level of risk and return attributes of an investor. Investors using the Capital MarketLine is able to identify stocks which could provide the maximum returns with minimum risk involved in Investments. On the other hand, the security market line allows the investors to detect the viability of their Investments and whether they are within the confinements of the market return and risk. The major difference between the capital market line and security market line are depicted as follows.
Risk to return relationship:
Capital market line and security market line has different relationships between the risk and return attributes of relative stocks. The capital market line relatively represents a graphical diagram, which represents the relationship between expected return an efficient portfolio and the total risk involved in investment. The graphical representation relatively allows investors to identify investment scope, which has the least risk and highest rate of return from investment. However, with the help of security market line investors are only able to detect the individual risk and return condition orphan investment opportunity. The function of systematic and non-diversifiable risk is identified with the help of security market line. In this context, Sembiring et al. (2016) stated that investors by detecting stock returns and risk are able to identify the maximum returns, which could be provided from the investment. On the other hand, Williams and Dobelman (2017) argued that risk involvement in investment relatively increases due to the presence of economic crisis.
Difference between Security Market Line and Capital Market Line
Measuring of risk:
Security market line relatively helps in measuring the risk with the help of Beta, which directly allows the investors to compare its investments with the market return and risk. The representation of risk with the help of security market line allow the investors to generate higher rate of return from Investments. On the other hand, the risk attributes of capital market line are calculated with the help of standard deviation which is calculated on the basis of total risk factor. The detection of total respective allows the capital market line identify stocks, which would generate the highest rate of return from investment while having minimized risk.
Portfolio efficiency:
Portfolio efficiency is a relatively detected with the help of capital market line and security market line. However, the security market line relatively defines the efficient portfolios which could generate the highest rate of return while having the risk involved in investment. The measure allows the investors to change Portfolio weights for deriving the overall investment option which would generate the highest rate of return from investment. On the other hand, security market line defines both efficient and non-efficient portfolios, which could allow investors to obtain high risk and return from Investments.
Equation calculation:
The calculation of security market line is relatively like the CAPM formula, which relatively helps the investors to detect the return from Investments. Moreover, the calculation directly allows the investors to take the maximum returns that could be generated from investments in accordance with the risk attribute of the stock. On the other hand, the calculation of Capital Market Line directly helps in detecting the highest rate of return provided from an investment and the in efficient portfolios that lie below the cml line (Christensen, Hail and Leuz 2016).
Figure 2: Depicting the minimum variance portfolio
(Source: Yang, Couillet and McKay 2015)
Minimum variance portfolio is considered a combination of stocks that is well diversified and consist of the least risk involved in investment. this detection of the minimum variance portfolio helps investors to reduce the risk from investment and maximize the profit by conducting different level of Investments. The minimum variance portfolio aims in detecting stock with the lowest risk and maximum return, which can be compressed in the portfolio to create the minimum variance portfolio. Minimum variance portfolio is identified to have the stocks with the lowest volatilities and price fluctuations. In addition, the portfolio consists of stocks which has the least risk involved in investment while the combination of stock would increase the rate of return in the portfolio. The concept of minimum variance portfolio was derived from mortgage backed securities, where the risk level of the investment was relatively low (Bodnar and Gupta 2015). However, the returns from investment in the mortgage backed securities was relatively high due to the combination of payments in a portfolio.
Importance of Minimum Variance Portfolio
The importance of minimum variance portfolio is depicted as follows.
Increment in Profits:
The minimum portfolio variance relatively allows investors to maximize the profit level as there is minimum risk involved in their Investments. The evaluation directly indicates that constant returns are provided by the minimum portfolio theory as risk involvement is relatively low. The companies and investors use this minimum variance portfolio to understand the minimum return that could be generated from a particular portfolio investment. The detection of minimum portfolio variance allows investors to adjust their risk value in accordance with their wrists capacity, which would generate the highest rate of returns from investment.
Reduction in negative impact from Capital market:
The minimum variance portfolio allows investors to identify stocks which has the least risk involved in Investments. This relatively indicates the reduction in negative impact, of capital market, on the share price movement of the stock. The stocks having low correlation and negative correlation are relatively used in the minimum portfolio variance to minimize or nullify risk involved in Investments. Furthermore, the evaluation also indicates that stocks having the least risk from capital market able to hedge their portfolio against volatile capital market. The conservative investors use the minimum portfolio variance to maximize the profit from the least risk involved in Investments (Maillet, Tokpavi and Vaucher 2015).
Safeguarding investment capital:
The investors and Portfolio managers are able to safeguard their investment capital with the help of minimum portfolio variance, as they are able to understand the investment scope of their portfolios. Investors main aim is to maximize their profits while having the least to this from Investments, whereas it is not possible for investors to have the least risk from Investments. The investors relatively have the minimum risk involved in investment, as the portfolio Evaluate the way on the basis of risk and return attributes.
Using appropriate combination of weights:
The minimum portfolio variance relatively allows investors to use appropriate combination of waste in the stock investment to generate the maximum returns while having the least this. The minimum portfolio variance directly indicates the level of investments on a particular stock that is listed in the portfolio. This allows the investors to identify the minimum investment on a particular stocks, which is been conducted to maximize profits. Therefore, minimum portfolio variance has allowed the investors to gauge into the Investment opportunity and take adequate decisions before conducting any kind of Investments (Bodnar, Parolya and Schmid 2018).
Detection of CAPM Formula for Required Rate of Return
Figure 3: Depicting the CAPM figure and Formula
(Source: Zabarankin, Pavlikoy and Uryasev 2014)
The above figure a relatively helps in identifying the formula and diagram of CAPM, which is used by investors to detect the overall rate of return from and Investment. The CAPM formula is relatively used for identifying the financial viability of a stock on the basis of risk. The formula directly indicates that the risk-free rate and market return is used in comparison to the beta of the stock to detect the maximum returns that could be provided from an investment. the figure relatively represents the overall concept of the minimum return that needs to be provided from an investment if the Beta is 1. This relatively indicates the positive Attribute of an investment which could allow the investor to generate the maximum level of return from a particular stock. However, the CAPM formula is considered non-effective for the investors, as the derivation of Beta is difficult. Moreover, CAPM formula is used in detecting the overall cost of equity which is used in the formula of weighted average cost of capital (WACC) (Barberis et al. 2015).
This relatively indicates that the CAPM Formula is used by different equations and formulas to derive the actual returns that will be generated from an investment. moreover, the simplicity of the calculation does not minimize its effect on the actual world practices. investment bankers and hedge fund managers use the formula for identifying the minimum rate of return that need to be generated from a particular investment. this helps in protecting the overall feasibility and viability of the CAPM Formula. The derivation of beaker is identified with the correlation between the market return and stock return and while the overall standard deviation of the returns of market is divided to detect the actual risk involved in Investments. The beta directly helps in detecting the impact of capital market on the price movement of shares, which could help in reducing the risk from investment (Aggarwal 2017).
The CAPM formula relatively uses the systematic risk in identifying risk return capability of a particular stock, which relates to the current reality of the investors in which maximum of the investments is conducted. the calculation directly helps in eliminating the unsystematic risk involved in Investments, which is not used by investors to derive the actual rate of return from Investments. The calculation indicates a viable approach conducted by organization to maximize the profit level and minimize any kind of risk that is affecting their profitability. Moreover, the CAPM formula allows the investors to derive relationship between return and systematic risk which is helpful in deriving different level of investment specific. the approach directly focuses its calculation on systematic risk which can be calculated, diversify, and detected by the investors. other formulas such as dividend discount model, weighted average Cost of capital model and other investment risk models used the required rate of return provided by CAPM to identify the level of return that could needs to be generated by the stock under systematic risk. Therefore, CAPM formula can be considered as the most viable calculation method, which would allow investors to get the required rate of return that needs to be provided from a stock (Jegadeesh et al. 2017).
Conclusion:
From the evaluation of above theories, it could be identified that with the help of capital market line the investors able to detect the portfolios that could generate the maximum rate of return from Investments. In addition, with minimum portfolio variance the same portfolios could be calculated based on least risk which would generate higher rate of return while reducing the risk involved in Investments. This kind of investment generate the maximum returns while having the least risk from the capital market. Lastly, the CAPM calculation relatively depicts the positive attributes of detecting the required rate of return from investments which allow investors to identify stocks with the highest rate of return from an investment.
References:
Aggarwal, R., 2017. The Fama-French Three Factor Model and the Capital Asset Pricing Model: Evidence from the Indian Stock Market. Indian Journal of Research in Capital Markets, 4(2), pp.36-47.
Barberis, N., Greenwood, R., Jin, L. and Shleifer, A., 2015. X-CAPM: An extrapolative capital asset pricing model. Journal of financial economics, 115(1), pp.1-24.
Bodnar, T. and Gupta, A.K., 2015. Robustness of the inference procedures for the global minimum variance portfolio weights in a skew-normal model. The European Journal of Finance, 21(13-14), pp.1176-1194.
Bodnar, T., Parolya, N. and Schmid, W., 2018. Estimation of the global minimum variance portfolio in high dimensions. European Journal of Operational Research, 266(1), pp.371-390.
Christensen, H.B., Hail, L. and Leuz, C., 2016. Capital-market effects of securities regulation: prior conditions, implementation, and enforcement. The Review of Financial Studies, 29(11), pp.2885-2924.
Jegadeesh, N., Noh, J., Pukthuanthong, K., Roll, R. and Wang, J.L., 2017. Empirical tests of asset pricing models with individual assets: Resolving the errors-in-variables bias in risk premium estimation.
Maillet, B., Tokpavi, S. and Vaucher, B., 2015. Global minimum variance portfolio optimisation under some model risk: A robust regression-based approach. European Journal of Operational Research, 244(1), pp.289-299.
Sembiring, F.M., Rahman, S., Effendi, N. and Sudarsono, R., 2016. Capital asset pricing model in market overreaction conditions: evidence from Indonesia Stock Exchange. Polish Journal of Management Studies, 14(2), pp.182-191.
Sharpe, W., 2017. Capital Market Theory, Efficiency, and Imperfections. Quantitative Financial Analytics: The Path to Investment Profits, p.445.
Williams, E.E. and Dobelman, J.A., 2017. Capital Market Theory, Efficiency, and Imperfections. World Scientific Book Chapters, pp.445-510.
Yang, L., Couillet, R. and McKay, M.R., 2015. A robust statistics approach to minimum variance portfolio optimization. IEEE Transactions on Signal Processing, 63(24), pp.6684-6697.
Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2), pp.508-517.
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