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Wednesday, April 13, 2016

Capital Market Line and Security Market Line and their difference

Capital Market Line (CML)
Capital Market Line (CML) is a line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.
The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio.
The CML is the relationship between the risk and the expected return for portfolio. The CML results from the combination of the market portfolio and the risk-free asset. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent. From a CML perspective, this portfolio is composed entirely of the risky asset, the market, and has no holding of the risk free asset ,i.e., money is neither invested in, nor borrowed from the money market account.

Security market line (SML)
Security market line (SML) is the representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta). It is also referred to as the "characteristic line".

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.
Difference between Capital Market Line and Security Market Line
1. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.
2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios.
4. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.
5. Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML.
6. While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis.
7. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML.

8. Finally, the Capital Market Line is considered to be superior when measuring the risk factors.