Capital Market Line, Security Market Line and Modern Portfolio Theory

Running head: CORPORATE FINANCE MANAGEMENT
Corporate Finance Management
Name of the Student
Name of the University
Author Note

1CORPORATE FINANCE MANAGEMENT
Answer to Part A
The Capital Market Line (CML) establishes a relation between the risk and return of
an efficient portfolio. The risk in Capital Market Line is calculated using variance or standard
deviation. Whereas the Security Market Line (SML) depicts a relation between the expected
returns and beta of any portfolio. In the Security Market Line beta is basically the volatility of
the portfolio. The major differences arising in the Capital Market Line and Security Market
Line is that the Capital Market Line takes into account only the efficient portfolios on the
other hand the security Market Line takes into account the individual as well as the inefficient
portfolios which are not included in the efficient portfolios. Further, Security Market Line is
the major concept that is used in the Capital Asset Pricing Model (CAPM). Both the concepts
of Capital Market Line and Security Market Line are discussed in details in the following part
along with the graphical analysis.
In the financial market there are basically two types of securities that are available to
the investors namely the risky securities and the risk free securities. The portfolio of all the
risky securities that are available to investors is called the market portfolio denoted by M.
The investors who are willing to invest in the market will hold a combination of both the
risky and the risk free securities. The above said combinations of the risk free and the market
portfolios will lie along the tangent drawn against the efficient frontier. Therefore, the Capital
Market Line is the line formed by taking into account the combination of the risk free and
risk less securities of all the investors in the security market (Brooks and Mukherjee 2013).
The relation that exists between the risk and return of the efficient portfolios is depicted using
the following equation,
Re=Rf + [ Rm −Rf
σm ]σ e

2CORPORATE FINANCE MANAGEMENT
Return
Risk
CML
Efficient Portfolio
Figure 1: CML
Source: By the Author
Where, Re = the expected return on the efficient profile
Rf = rate of return on the risk free assets
Rm = expected return on market portfolio
σ m = variance of the market portfolio
σ e = variance of the efficient portfolio
The slope of the Capital Market Line is the term [ Rm−Rf
σm ]. The slope measures the
increase in return due to one unit increase in the risk. This term also shows the risk premium
associated with the portfolio. The graphical analysis provided below.
Now the Security Market Line depicts all the inefficient as well as the individual
securities which do not lie in the efficient frontier (Jordan 2014). The Capital Market Line
does not include all these inefficient points. The relation between the returns and volatility of
the portfolio is depicted using the following equation,
Ri=Rf + βi (Rm −Rf )

3CORPORATE FINANCE MANAGEMENT
Return
β
1
SML
Figure 2: SML
Source: By the Author
Where, Ri = expected return of the ith stock
Rf = rate of return on the risk free assets
Rm = expected return on market portfolio
βi = volatility of ith asset
Here in the Security Market Line β depicts the slope of the line. The sensitivity of the
portfolio with respect to the changes in the market returns is measured by this term β. When
the value of β is zero then the expected return from a portfolio will be similar to the risk free
rate (Pandya 2013). However if the value of β is greater than one then the prices of the stocks
are more sensitive as compared to the market. The stocks with higher values of β are
considered as more risky as compared to the stocks with low β. The SML depicts a cross
sectional analysis of different stocks. The mean return on the two stocks is proportional to the
β values. The graphical representation of the Security Market Line is provided below.
The above diagram shows the Security Market Line with beta portfolio. The major
difference between the SML and the CML is the term beta. The risks associated with a