Difference Between CML And SML
The optimum portfolio is that in which the investor get a high return, but for building the optimal portfolio the risk factor of the investment is a very important aspect which is to be considered. The risk factor of the asset depends on the attitude of the investor towards their risk-bearing capacity (Sinha, Chandwani and Sinha, 2015). Investors have different risk behaviour capacity therefore by combining a different combination of securities they select the portfolio various tools are applied. The present study emphasis on the difference between capital market line and security market line for assessment of the efficiency of the developed portfolio by the investor. Further, it evaluates the capital assets pricing model in terms of assessing the efficiency of the risk and return of the portfolio so that investor can get maximum return on their investment. Along with this, in this study minimum portfolio variance strategy is also analyzed by considering suitable concepts.
Assessment of capital market line and security market line
In capital assets pricing model, the capital market line showed the balance between the risk and provided a return by the portfolio for achieving the efficient portfolio for the investor (Williams and Dobelman, 2017). In this method, the position at the risk-free rate for the borrowings as well as lending is selected by the investor, by which the maximum return on the existing risk, can be achieved.
Graphical representation of Capital market line
Figure 1: Capital market line
(Source: Smirnov, 2017)
By analyzing the above graph, it has been evaluated that capital market line shows the different portfolio by considering market portfolio and risk-free return in the market, this theory assumes that securities in the market is wholly varied and carries only systematic risk. Therefore, the expected return for the investor will be equal to the expected return for the market as a whole.
Further, the efficient frontier in the above graph shows the combination of the portfolio, which includes an only risky asset in the several proportions (Sharpe, 2017). The intersection between the CML and the SML called the market portfolio. Further, if the investor is rational, that means they will accept the higher risk only when the return increases proportionately with the risk, for this concept market portfolio on the efficient frontier is the optimal portfolio for the investor.
In the capital assets pricing model, the security market line generally applies to the investor by evaluating whether the investment is generated the expected return against its level of risk. The security market line compares the different level of risks such as systematic risk or the market risk against the return expected at the market on a particular point in time (Akbas et al. 2016). The SML defines the risk and returns from the securities after considering the time value of money and the risk premium. This concept of the security market line depicts that the investor must get the compensation for the time value of the money and also the level of risk which is accepted by the investor on their investment.
Graphical representation of Capital market line
Graphical representation of the security market line
Figure 2: Security market line
(Source: Smirnov, 2017)
The above graph of SML shows the varied level of the risk against the expected return of the market (Hong and Sraer, 2016). The security which is above the security market line is considered as undervalued security because it shows that the return from the security is higher as compared to the inherent risk associated with the security. Further, the security below the security market line is considered as an overvalued security, due to the return generated from the security is less than the inherent risk from the security.
Generally, the security market line is applied by the investor for comparing the two similar securities, which generate almost the same return, by which the investor can determine which of the security has less risky in relation to achieving the expected return.
Therefore on the basis of the above study, it has been seen that although the CML and the SML are applied in the context on the capital asset pricing model, both measures the risk and return of the portfolio by applying some different parameters (Jylhä, 2018). The capital market line uses the risk-free rate, and the associated risk of the particular portfolio to calculate the required return on the portfolio, while the SML shows the varied level of the risk against the expected return of the market as a whole on that particular point of time. Further, both the concepts are applied by the investor to find out the risk associated with the investment, but the risk is measured by CML through the standard deviation of the security, on the other hand, SML measures the risk through the beta coefficient of the security. The graphical representation of the CML shows the efficient frontier, by which the efficient portfolio of the security can be evaluated, while the graphical representation of the security market line shows the both efficient and the non-efficient portfolio. Moreover, the capital market line ascertained the market portfolio and the risk-free asset while the security market line ascertained all the factors of the security. The CML measures the risk and return of the efficient portfolio while the SML measures the risk and return for the individual shares in the market. Further for measuring the risk factors of the security implementation of the CML is regarded well than the SML.
The equation of the CML is-
Graphical representation of Security market line
In the above formula return of the portfolio denoted by p, the return of the market folio is denoted by RT, and the σT is the standard deviation of the market folio. Further, the risk-free rate of return and balance between the risk and return is denoted by the (RT– rf)/ σT
The equation of the SML is –
|
Es = rf + Bs (Emkt – rf) |
Where:
rf= the risk-free rate
Bs = the beta of the investment
Emkg = the expected return of the market
Es =the expected return on the investment
Therefore it has been concluded by the above evaluation both the capital market line, and the security market line is the capital asset pricing model determine the balance between the risk and return of the securities by considering the different aspect of the factors of the security.
Minimum variance portfolio refers to that portfolio in which the individual asset is considered risky, but while the asset is combined together with the results in the lower risk and the anticipated return (Yen, 2015). In other words, minimum portfolio variance is the diversified portfolio, which combines the securities for reducing the price volatility of the overall portfolio.
Generally, the portfolio means a set of the investment keep by the investor in one account or the combination of the securities and account kept by one investor (Coqueret, 2015). For creating the minimum variance portfolio, an investor is required to have a combination of low volatility investment so that the market risk can be reduced as the high volatility leads to higher market risk or the investor through the combination of volatile investment with low correlation with each other can also build the minimum variance portfolio.
Minimum portfolio assists in assigning the weight to the individual security in such as manner by which the risk of the overall portfolio can be minimized. Minimum portfolio variance does not affect by the expected return of the security. It depicts the lowest risk portfolio among all risk and returns portfolio from the efficient portfolio. Though the application of the minimum portfolio variance, investor, determine the securities in which the investor want to invest along with limitations, can obtain the estimate of the returns, volatility, correlations of the investable securities , then by applying this estimation in the real world, the investor gets the reliable output from the investment in the security (Yang, Couillet and McKay, 2015). Moreover, the investment that has the low correlation is described as that security that performs differently at the same market and the economic environment, the investor on the basis of the minimum portfolio variance can diversify the portfolio in such a manner by which the volatility can be reduced. For instance, minimum portfolio variance implements by the investor for investing in the stock mutual fund and the bond mutual fund (Bodnar and Gupta, 2015). Since the relation between the prices of the stock and the bond are converse, it means if the price of the particular security is increasing then the bond price is definitely decreasing and vice versa, which leads that between the price of the stock and the price of the bond very low correlation exist. So that by application of the minimum portfolio variance strategy investor can combine investment types of risky and non-risky asset, so that can achieve the high relative return without high risk.
Importance of the CAPM Equation
The capital asset pricing model establishes the linear relationship between the systematic risk and the required rate of return on the investment. In this model, Systematic risk can be defined as a risk which affects the overall market, and the investment may be in the stock market securities or in the operations of the business (Zabarankin, Pavlikov and Uryasev, 2014).
The equation of the CAPM is given below-
In this model, the assumption has been made that an investor should be compensated only for the systematic risk in their portfolio because due to the diversification of the portfolio unsystematic risk can be mitigated. Further, this model provides the discount rate better than any other pricing model for the investment appraisal technique (Piamsuwannakit et al. 2015). Apart from the above, this model also considers the systematic risk of the company is related to the overall risk of the concerned market. CAPM equation suggests that investor should be earned for the time value of money and the risk associated with their investment. Here the risk-free rate in the equation depicts that investor should be compensated placing their investment in any investment over the time along with this; it also shows that amount of the compensation required by the investor for taking the additional risk. It can be measured by the return of the market over the risk-free interest rate through the risk measure that is Beta of the security. Beta denotes the volatility function of the market and the security along with the correlation between the security and the market, by which the investor can get to know about the how risky is the asset as compared to the overall market.
Due to the all above reason the equation of the capital asset pricing model more relevant than other equation at the time of evaluating the return provided by the investment.
Conclusion
On the basis of the above study, it has been evaluated that CML and SML are the two technique of the capital asset pricing model, by which the investor can assess their optimal portfolio. However, the method of measuring the risk and return of the security can be done by both as they consider different factors but have the same objectives. Further, the investor through the minimum portfolio variance strategy can build the well-diversified portfolio by combining the risky individual asset with the less risky asset, which leads to the maximum return on the investment at the minimum risk. Apart from this, the capital asset pricing model is the best method for determining the optimal portfolio, because the equation of the capital asset pricing model considers various factor by which the risk and the return of the securities can be affected.
References
Akbas, F., Armstrong, W.J., Sorescu, S. and Subrahmanyam, A., 2016. Capital market efficiency and arbitrage efficacy. Journal of Financial and Quantitative Analysis, 51(2), pp.387-413.
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.
Coqueret, G., 2015. Diversified minimum-variance portfolios. Annals of Finance, 11(2), pp.221-241.
Hong, H. and Sraer, D.A., 2016. Speculative betas. The Journal of Finance, 71(5), pp.2095-2144.
Jylhä, P., 2018. Margin requirements and the security market line. The Journal of Finance, 73(3), pp.1281-1321.
Piamsuwannakit, S., Autchariyapanitkul, K., Sriboonchitta, S. and Ouncharoen, R., 2015, October. Capital asset pricing model with interval data. In International Symposium on Integrated Uncertainty in Knowledge Modelling and Decision Making (pp. 163-170). Springer, Cham.
Sharpe, W., 2017. Capital Market Theory, Efficiency, and Imperfections. Quantitative Financial Analytics: The Path to Investment Profits, p.445.
Sinha, P., Chandwani, A. and Sinha, T., 2015. Algorithm of construction of optimum portfolio of stocks using genetic algorithm. International Journal of System Assurance Engineering and Management, 6(4), pp.447-465.
Smirnov, Y., 2017. Capital Market Line – CML. [Online]. Available through < https://financialmanagementpro.com/capital-market-line-cml/>. [Accessed on 17th September 2018].
Smirnov, Y., 2017. Security Market Line – SML. [Online]. Available through < https://financialmanagementpro.com/security-market-line-sml/>. [Accessed on 17th September 2018].
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.
Yen, Y.M., 2015. Sparse weighted-norm minimum variance portfolios. Review of Finance, 20(3), pp.1259-1287.
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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