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Understanding Security Market Line and Capital Market Line in Financial Management

   

Added on  2023-06-07

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Running head: FINANCIAL MANAGEMENT
Financial Management
Name of the Student
Name of the University
Author note:
Understanding Security Market Line and Capital Market Line in Financial Management_1

2FINANCIAL MANAGEMENT
Table of Contents
Introduction......................................................................................................................................3
Discussion........................................................................................................................................3
The SML:.....................................................................................................................................3
Definition:....................................................................................................................................3
Equation:......................................................................................................................................4
Graphical representation:.............................................................................................................4
Limitation....................................................................................................................................5
The CML:....................................................................................................................................5
Definition:....................................................................................................................................6
Equation:......................................................................................................................................6
Graphical representation:.............................................................................................................7
Limitation....................................................................................................................................8
The Fundamental difference between SML and CML................................................................9
The importance of minimum variance portfolios........................................................................9
The Advantages of CAPM equation whike calculating the rate of return.................................10
Conclusion.....................................................................................................................................11
References......................................................................................................................................12
Understanding Security Market Line and Capital Market Line in Financial Management_2

3FINANCIAL MANAGEMENT
Introduction
A capital asset refers to the properties that are associated with the business of any kind.
The CAPM or the capital asset pricing model is the model that helps in the process of elaboration
of the link between the anticipated return of the asset and the systematic risk that is used widely
in the context of the stocks. In case of securities that are risk bearing, the CAPM is widely used.
This also helps in the generation of return that are expected for the assets and evaluating the cost
of capital.
In this context, the security market line refers to the line that is drawn that helps in
serving graphically representing the model of capital asset pricing. The SML also known as the
characteristics line which is visual capital pricing model that represents both risks and the return.
On the other hand, the CML stands for capital market line refers to the model that helps
in the pricing of asset CAPM mechanism. It represents the trade-off between return for portfolios
that are efficient and the various risks that are associated (Bodnar, Mazur and Okhrin 2017). It
can be said to be a theoretical concept which elaborates the various portfolios that efficiently
collaborate the rate of return that are free from risk as well as the risky assets market portfolio.
Discussion
The SML:
Definition:
The SML or the security market line refers to the optical depiction of the model of
capital asset pricing or CAPM. It represents the link between the return from security that is
expected and the associated risk. The measurement of risk is done by the beta coefficient (Chow,
Understanding Security Market Line and Capital Market Line in Financial Management_3

4FINANCIAL MANAGEMENT
Kose and Li 2016). It can also be said in this context that, the representation of the SML shows
the anticipated return for any beta that is given or highlights the associated risk with any
expected return that is given.
Equation:
As highlighted in the above definition the SML is on the basis of the CAPM model that is
shown below:
E(Ri) = RF + βi × (E(RM) - RF)
Where, E(Ri) is an expected return of a security, RF is a risk-free rate, βi is a security’s
beta coefficient, and E(RM) is an expected market return.
Graphical representation:
In the SML graph the x-axis is shown by the beta, and expected return is represented in
the y-axis. The beginning of the line represents the risk-free rate value:
Understanding Security Market Line and Capital Market Line in Financial Management_4

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