Market Line and Capital Assets Pricing Model

This report shows the graphical presentation of the undertaken security market line and capital market line. It shows how CAPM method is used to compute the required return of the investors. The graphical representation of the CML and SML will help investors to assess the low risk and high return on his investment. The main issue in computing the right amount of cost of capital in particular project is based on setting the risk free rate of return.

Running head: CAPITAL ASSET PRICING MODEL 0
CAPM in Market Line Segment
CAPM
[DATE]
HP
[Company address]

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Introduction
This report shows the graphical presentation of the undertaken security market line and
capital market line. It shows how CAPM method is used to compute the required return of the
investors. The graphical representation of the CML and SML will help investors to assess the
low risk and high return on his investment. The main issue in computing the right amount of
cost of capital in particular project is based on setting the risk free rate of return. Many
investors might face issue to undertake the right base at which it will reflects the exact cost of
capital and return associated with the particular accepted project. This essay will focus on the
graphical representation of the CML and SML and the computation of the cost of capital
through the CAPM method.
Explain and graphically depict how Security Market Line
In CAPM, Capital Market Line is determined when in portfolio there is trade-off between
risk and return, it refers to as CML. This helps in determining the optimum point where
company could have optimum risk and return associated with the particular project. On the
other hand, security Market Line is formulated to determine the market risk related to the
marketable securities against the expected return. It is an investment evaluation tool which
helps to evaluate systematic and systematic risk associate or plotted against the expected rate
of market return plotted at the single point. In CML risk is measured and plotted on graph
CML graph portray efficient portfolios while in SML both efficient and non-efficient
portfolios are depicted by the graph. It is analyzed that where SML determines all the security
related factors ,market portfolio and risk free assets are determined by CML. Risks or return
for individual assets/stocks are determined by SML while risk or return for efficient
portfolios are shown by CML. The main Importance of minimum price variance portfolio is
related to determine the expected return, risk of individual risky assets (Brigham, and
Ehrhardt, 2013).
In these two different cases, relation between the risk and return associated with the
investment projects has been determined. In case of model of Sharpe, liner against the case is
free from sharp liner and return is associated with the premium and beta of the market. It is
analyzed that in case of the risky assets and unrestricted shorts selling of the risky portfolio
there might be chance of the high risk and beta associated with the project. The main

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assumption which is determined is that the premium beta is positive and expected return on
the market (Cikaliuk, et al. 2017).
.
(Source: Prezi 2017)
This diagram shows the CML and SML of the invested return. It is considered that capital
market line reflects the trade-off between the return and risk of the invested capital. In case of
the CML, investors choose the position on the CML in equilibrium by borrowing or lending
at the risk free rate (Dahir, Mahat, and Ali, 2018). The SML could be described as graphical
presentation of the CAPM model. It is analyzed that if the expected return of the security is
plotted over and above the SML line then it is determined as undervalued and if it is not
given then it will set up risk return trade off. These two graphs are drawn individually with a
view to make the proper graphical presentation and reflect the modes at which investors will
have optimum return with the given level of risk (Yahoo finance, 2018).

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Importance of minimum variance portfolio
It is considered that diversified portfolio contains the assets that are accompanied with the
high risk on the individual basis but also have lower level of risk related to anticipated risk
return when pooled together.
In minimum variance portfolio, expected return and risk level of individually risky assets are
at the lowest and individual portfolios are more risky than the portfolio as a whole. When the
assets are pooled together they help us to get more benefit and high return. It helps to
possibly minimize price volatility in portfolios. .
Why CAPM equation might be more relevant than other equations when calculating required
rate of return.
The capital assets pricing model is used to identify and evaluate the financial performance of
company. Ideally, capital assets pricing model is used to evaluate the cost of capital and
accepting the best possible projects in the undertaken project. It is analyzed that when we
want to establish relationship between RISK and expected return of investing in a security
than we usually use CAPM model
CAPM Equation-
Relevancy of CAPM Equation and pros of CAPM Model
The main relevancy of using the CAPM equation is related to time value of money and
cost of capital used in the particular project.

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The idea behind using CAPM Model is to get two kinds of compensation: time value of
money & risk. As we all know that no model is perfect but CAPM Model somehow
developed more accessible approach to diversification. It takes into the account systematic
risk which is not taken by other return models. (Systematic risk or market risk is also known
as “un-diversifiable risk’. This un-diversified risk is comprised of entire market segment
having inherent uncertainty i.e. Fluctuations in the market occur every so often). It reduces
the unsystematic risk (this kind of risk is associated with the company we have invested in)
and provides diversified portfolio. CAPM model’s calculation is simplistic and it provides
probably all the possible range of outcomes around the required rate of return with a sense of
confidence.
When other required rate of return calculations cannot be used in business and other financial
risk variability than CAPM calculations can be used. Investors looking to maximize growth
in the portfolio should maintain a larger location to risky assets and this can be made possible
by CAPM Model. The risk free rate of return is determined on the basis of return available on
the treasury bonds and gilt securities and risk premium market is determined on the basis of
market risk associated with the industry. The beta of company is determined on the basis of
the share price movement of the company and all ordinary share price index. However, the
computation of the beta is based on the share price fluctuation and all ordinary share price
movement. It is computed by using the regression analysis model in both the share price
movement.
This could be depicted by using the clear example such as if the risk free rate of return of
company is 2% and market beta of company is 1 and the expected market return is 12% then
in this case the company could be having expected rate of return or cost of capital 28%
In case of accepting the particular project, CAPM model is very much useful. Investors while
using the CAPM model needs to establish the relation between the risk and return related to
the accepted project. It is analyzed that investors could choose only those portfolios which
have low variances and specific expected return and cost of capital. This model is known as
Markowitz model (Fard, and Falah, 2015).

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(Source: Capital assets pricing model, 2017)
Figure 1 The above given chart reflects that if the CAPM amalgamated with the efficient
frontier and extended lines for the risk free rate of return point and the extended line for risk
free return points on y axis (Fernandez, 2015). The inequality of the borrowing and rate
determined for the purpose of lending. This frontline helps in identifying the plausible causes
of difference between the risk and return of the accepted project. It is analysed that mean
variance efficient with the frontier with the riskless assets is determined on the basis of the
risk and associated return with the particular project. Investors would accept those projects
which will offer higher return with the minimum risk model. This is hard to find the optimum
investment point which could strengthen the overall outcomes of the investors in context with
the investment option (Prezi. 2017). The above given graphical representation reflects the
changes in the return with the increase risk of the particular accepted project.
Recommendation/ conclusion
After analysing all the details, crux of this research report is that these both SML and CML
are used to determine the relation between the cost and return of the company while
accepting the particular project. It is analysed that if investors wants to invest his capital then
it could do so by keeping its money invested in long run if the market risk premium is high.

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There are several other models which might be used by investors to find out its own
economic point at which it could have its return or risk as per their acceptance in related to
risk and return of the particular project. Therefore, investors while analysing the SML and
CML need to identify the market line first then the further comparison between both should
be made. Market Line is formulated to determine the market risk related to the marketable
securities against the expected return. This reflects the true base for the comparison in both.
The CAPM model has several advantages and benefits associated with the computing the
return and risk associated with the project. This model does not only consider the systematic
risk and unsystematic risk which company might face in its business. There are several other
models which could be used by the researchers while computing the cost of capital such as
dividend growth model, Gordon Model (Zhu, 2014).

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References
Brigham, E.F. and Ehrhardt, M.C., (2013). Financial management: Theory & practice. 2nd ed.
Australia: Cengage Learning.
Capital Assets pricing model, (2017) Capital Asset Pricing Model (CAPM)? [Online]
Available from https://accountingexplained.com/capital/equity-valuation/capital-asset-
pricing-model [Accessed on 14th September 2018]
Cikaliuk, M., Erakovic, L., Jackson, B., Noonan, C. and Watson, S., (2017). Board
Leadership for Strategic Transformation: Aligning Diversity Initiatives at the Bank of New
Zealand. 3(1), pp.21-32.
Dahir, A.M., Mahat, F.B. and Ali, N.A.B., (2018). Funding liquidity risk and bank risk-taking
in BRICS countries: An application of system GMM approach. International Journal of
Emerging Markets, 13(1), pp.231-248.
Fard, H.V. and Falah, A.B., (2015) A New Modified CAPM Model: The Two Beta
CAPM. Jurnal UMP Social Sciences and Technology Management Vol, 3(1). pp.23-28.
Fernandez, P., (2015) CAPM: an absurd model. Business Valuation Review, 34(1), pp.4-23.
Prezi. D, (2017) CAPM: Assumptions and Limitations | Securities | Financial Economics
[Online] Available from
http://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-
limitations-securities-financial-economics/29904 [Accessed on14th September 2018]
Yahoo finance, (2018), Online] Available from https://in.finance.yahoo.com/[Accessed on
14th September 2018]
Zhu, J., (2014). Quantitative models for performance evaluation and benchmarking: data
envelopment analysis with spreadsheets 17(2), pp.231-248.

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