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Security Market Line (PDF)

   

Added on  2021-05-31

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Explain and graphically depict how Security Market Line (SML) is different fromCapital Market Line (CML). Identify and discuss the importance of minimum varianceportfolios?Why CAPM equation might be more relevant than other equations whencalculating required rate of return.CML is the abbreviated version of Capital Market Line and SML stands for Security MarketLine. Both these lines are basically the graphical representation of the Capital Asset PricingModel (CAPM). The capital market theory reveals a crucial step towards how stakeholdersshould ponder over their investment procedures. Further to this, it is the CAPM whichfurthers down the capital market theory in a manner which permits investors to examine therisk-return trade-off for both diversified portfolios as well as single securities. It is the CAPMwhich utilises the SML and CML. However both of these lines are very different bothgraphically as well as conceptually. The under mentioned paragraph would enable detailingabout the difference between the SML and CML.The CML is the line that reveals the rate of returns, that is dependent upon rates of returnwhich is free from all risks and levels of risk for a particular portfolio. Whereas SML whichis also connoted as Characteristic Line, is a graphical presentation of the risk which isprevalent in the market and the return at a particular time. Another difference between thetwo terms is the methodology of measuring risk factors. CML measures the risk factor by themethod of standard deviation or via the total risk factor whereas the SML measures the riskfactor with the help of Beta Coefficient which enables to search the security’s perilinvolvement to the portfolio. The third dissimilarity between the two is that the CapitalMarket Line’s graph defines which portfolios are performing well and competent by naturewhereas the Security market Line graph determines both competent as well as non-competentportfolios (Lee & SU., 2014). CML is a narrowed terminology as it establishes only marketportfolio and those assets which are free from any kind of risks, whereas on the contrarySML enables determination of all the security variables and factors. In contrast to the CapitalMarket Line, the Security Market Line reveals the anticipated returns of the single assets.Thereby it can be construed that while CML shows the risk and return for the portfolioswhich yield good results and are competent by nature, the SML establishes the risk or returnfor each and every stock or asset separately (differencebetween.net., 2016). However, ascompared to the Security Market Line with the Capital Market Line, the latter is construed tobe superior when measuring the risk variables.

Source: http://financialmanagementpro.com/capital-market-line-cml/In the said CML graph, two portfolios are assumed:1.Lending (non-leveraged) Portfolio A with a standard deviation 5%2.Borrowing (Leveraged) Portfolio B with standard deviation 15% (Smirnov., 2016)Source: https://thismatter.com/money/investments/capital-asset-pricing-model.htmIn the above SML graph , it is presumed that a market return of 12% and a risk free rate of4%.

Thus Y axis of the Capital Market Line shows the expected return and the X axis shows thestandard deviation and the Y axis of Security Market Line shows the level of return that isneeded on the individual assets and the X axis reveals the level of risk represented by Beta. Minimum Variance Portfolio (MVP) is a portfolio structuring model which may apparentlyseem to be complicated but the same can enable maximise returns and reduce the riskconsiderably, which is the main aim of all the investors across the globe. If one can formulateand develop a minimum variance portfolio successfully, the investor can gain the bestpossible result with minimum risk. Therefore it can be said that it’s a type of a “have yourcake and eat it too” tactics in the investment globe (Thune, 2017). Before its importance is discussed it is very crucial to know what it is actually. The minimumvariance portfolio is a portfolio of stocks and securities that come together to reduce the priceinstability of the entire portfolio. Volatility which a more commonly used word than variancein the investment world, is basically a statistical measurement of a specific stock’s pricemovement i.e. its ups and downs. Further to this, the instability of a security is alsoexchangeable in line with the risk in the market. Thus more the volatility of a particular stockor portfolio, the higher the market risk and vice-versa. Therefore it can be said that MVP is aspread of investments with the least amount of volatilities i.e. those securities which havelowest chances of fluctuate with regards price as they have the least amount of sensitivitytowards risk. Investors who are not wanting and desirous to undertake higher risks shouldtake into account the minimum variance portfolio. The concept is explained int he belowgraph

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