Capital Market Line, Security Market Line and Minimum Variance Portfolio in CAPM

FIN200 Assignment, Trimester 2
2018________

CAPM
Security Market Line (SML) is different from Capital Market Line (CML).
In relation to CML, the same is utilized to determine the return through an effective portfolio.
Furthermore, such return relies upon various factors like beta, risk-free rates, etc. Therefore,
CML can be used to depict a positive liner interconnection betwixt portfolio beta and returns
on a whole. In addition, when any tangent is drawn from an effective portfolio, the CML
(capital market line) can be seen when the expected return and risk-free return matches each
other. Based on the Markowitz theory, in the prevalence of risky assets, the optimal portfolio
is the one situated in the effective frontier part and it relies on the attitude of investors
towards the risk (Nielsen, 2006). Besides, investors have a distinct aversion of risk and hence,
they choose distinctly and they always choose a portfolio made up of a varied admixture of
securities. Through the introduction of a risk-free asset that can be purchased and sold in a
short tenure, it has been seen that the effective frontier is linear and the portfolio choice is
independent from the attitude of individuals towards risk.
This portfolio remains along the frontier concave and possesses the higher ratio
and can be easily sought by plotting a line that can intersect the y-axis in the Rf and is also
tangent to the concave set. Nevertheless, all the investors possess the same opportunities and
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CAPM
the same portfolio of tangent. Therefore, the CML attains from an effective part of the
minimum variance frontier that is interrelated to the feasibility to purchase or sell any risk-
free asset. Capital market line (CML) is therefore considered as the graph of the needed risk
and return of a risk-free asset’s portfolio and a bunch of other risky assets that can provide
the best trade-off of risk-return. Nevertheless, it is an important situation of allocation of
capital line that is tangent to the efficient frontier and its slope depicts the Sharpe Ratio. In
relation to this, the CML plays a key role in accounting for the risk-free assets and therefore,
it remains in the lead when it comes to effective frontier (Banbura et. al, 2015). Moreover, all
the other portfolios accommodate the exact Sharpe ratio as that in relation to the market
portfolio. Besides, while purchasing or making heavy investments in any portfolio or assets,
one relevant factor that must be taken into due consideration is that the Sharpe ratio must be
verified and the capital market line ratio of such portfolio or asset must be verified as well
(Nielsen, 2014). Further, if an asset’s Sharpe ratio remains above the ratio of CML, then the
purchase mode must happen and if it remains lesser than the CML ratio, then it must be sold
(CAPM, 2017).
Security market line (SML)
The SML can be regarded as a graphical reflection of the market or systematic risk when
compared to the market risk return on a whole at a specific time and reflects all securities that
are believed to be marketable in nature. Furthermore, the security market line can be regarded
as a powerful measure in ascertaining whether a selected asset for the inclusion process in a
portfolio can play a key role in offering a desired return rate.
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