Capital Market Line (CML) vs Security Market Line (SML)

Summary

This video compares the Capital Market Line (CML) and the Security Market Line (SML), two critical concepts in finance. The CML represents the trade-off between total risk (standard deviation) and return for portfolios combining a risk-free asset and the market portfolio, with its slope reflecting the Sharpe ratio. The SML, on the other hand, shows the relationship between systematic risk (beta) and return for individual assets, according to the Capital Asset Pricing Model (CAPM). The video explains their equations, key differences, and practical applications in portfolio and asset pricing, helping viewers understand these essential financial tools.

Takeaways

• 😀 The Capital Market Line (CML) represents the trade-off between risk and return for portfolios consisting of both risky assets and a risk-free asset.
• 😀 The CML is derived from the Efficient Frontier, which shows portfolios with the highest expected return for a given level of risk.
• 😀 The Security Market Line (SML) shows the trade-off between systematic risk (beta) and return for individual assets or portfolios.
• 😀 The CML uses total risk (measured by standard deviation, σ), while the SML uses systematic risk (measured by beta).
• 😀 The CML's slope is the Sharpe ratio, which is the market risk premium divided by total risk, while the SML's slope is the market risk premium.
• 😀 The CML argues that all investors should hold the same market portfolio (e.g., an index fund) in combination with risk-free assets.
• 😀 The SML helps price individual securities by determining the expected return based on their beta, which measures their volatility relative to the market.
• 😀 The risk-free rate is the intercept on both the CML and SML, but the slope differs between the two lines based on the type of risk measured.
• 😀 Securities below the SML are considered overvalued, offering too low a return for their level of risk, while those above the SML are undervalued.
• 😀 The CML is used for portfolio analysis and suggests optimal portfolios combining risky assets and risk-free assets, while the SML is focused on individual securities' risk-return profiles.

Q & A

What is the primary difference between the Capital Market Line (CML) and the Security Market Line (SML)?

The CML shows the trade-off between total risk (standard deviation) and expected return for portfolios consisting of the risk-free asset and the market portfolio, while the SML shows the trade-off between systematic risk (beta) and expected return for individual securities or portfolios.

What does the Capital Market Line (CML) represent?

The CML represents the best risk-return trade-offs for portfolios that combine the risk-free asset and the market portfolio. It shows the highest expected return for a given level of total risk.

What does the Security Market Line (SML) represent?

The SML represents the expected return for individual securities based on their systematic risk (beta) relative to the overall market. It is a graphical depiction of the Capital Asset Pricing Model (CAPM).

How is the risk measured on the Capital Market Line (CML)?

Risk on the CML is measured by standard deviation, which reflects the total risk of a portfolio.

How is risk measured on the Security Market Line (SML)?

Risk on the SML is measured by beta, which represents the systematic risk that cannot be diversified away and indicates how much a security’s price moves relative to the market.

What is the significance of the slope of the Capital Market Line (CML)?

The slope of the CML represents the Sharpe ratio, which measures the return per unit of total risk. It reflects the efficiency of a portfolio in terms of risk and return.

What is the slope of the Security Market Line (SML) and what does it represent?

The slope of the SML is the market risk premium, which is the difference between the expected return of the market and the risk-free rate. It reflects the return expected from the market for taking on additional risk.

What does the efficient frontier represent, and how is it related to the Capital Market Line (CML)?

The efficient frontier represents portfolios that have the highest expected return for a given level of risk. The CML is tangent to the efficient frontier, showing the optimal mix of the risk-free asset and the market portfolio.

What happens when you move along the Capital Market Line (CML)?

Moving along the CML involves changing the allocation between the risk-free asset and the market portfolio. If you move to the right, you are increasing your investment in the market portfolio, and if you move to the left, you are allocating more to the risk-free asset.

How does the Security Market Line (SML) help in evaluating individual securities?

The SML helps evaluate individual securities by comparing their beta (systematic risk) to the expected return of the market. Securities above the SML are undervalued, while those below the line are overvalued.