CLA1 BUS 624 Investment Analysis PDF

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CLA1: Capital Asset Allocation Model: SML and CML Manish Dangol Presidential Business School Westcliff University BUS 624 Investment Analysis Professor: Mandip Luitel March 31, 2021

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Abstract This CLA1 paper deal with the discussion of the security market line (SML) and capital market line (CML) with its essential features. To understand these liner, equations and graphs of both market line are presented in the paper for easy understanding. Furthermore, price behavior under SML and CML are explained with the example. And at the end inefficient portfolios are define with the graph.

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Security Market Line (SML) Security Market Line also known as characteristic line that line drown on chart that represent capital asset pricing model (CAPM) that reflect expected return of market at different level of systematic or market risk. In chart, X-axis represent risk which also determined through the beta coefficient and y-axis represent the expected return. The slope of the SML is equal to the market risk premium which is (E(RM) – Rf) and reflects the risk return trade off at a given time. Higher the market risk premium steeper the slope and vice-versa (Thakur, n.d.). SML is popularly used to determine whether the portfolio investment has favorable expected return under which the investor can bear the risk, in result help in evaluating and comparing the efficient and nonefficient portfolios.

Fig: Security Market Line.

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SML are drawn from the risk-free return (Rf) where risk is equal to zero as shown of the above figure and from that with the systematic risk increase expectation risk will also increase. SML also help to determine whether the individual securities or assets are undervalued or the overvalued. The assets or securities that lies above the SML line are undervalue where as the assets or securities that lies below the SML lune are overvalue. The equation of SML is as follows: E(R) = Rf + β [E (Rm) - Rf] Whereas, E(R) = Expected return Rf = Risk free rate β = Systematic risk or beta coefficient E(Rm) = Expected return on market portfolio [E(Rm) - Rf] = Market risk premium (slope) Features of Security Market Line 

SML is the graphical representation of risk free assets and market portfolio

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When the security or assets has zero beta then the expected return is equal to risk free return

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Slope of line is equal the market risk premium which is different between expected return on market and risk free [E(Rm) - Rf]

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Higher the market risk premium steeper the slope and vice-versa

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Beta of SML has direct proportion to expected return which means higher the systematic risk (beta) higher the expected return and vice-versa.

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Those assets or securities that lies above the SML line are undervalue because the position on the chart indicates that the security offers a greater return against its inherent risk (Kenton, 2020).

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The assets or securities that lies below the SML lune are overvalue because the investor would accept a smaller return for the amount of systematic risk associated.

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SML is evaluate under only systematic risk by ignoring unsystematic risk

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SML is use to evaluating and comparing the efficient and non-efficient portfolios.

Capital Market Line (CML) CML is a graphical representation of all the portfolios that optimally combine risk and return for the given Sharpe ratio (Ganti, 2021). It show the relationship between risk and the return of the portfolios. In CAL, risk free assets and risky portfolio are evaluate and compare the efficient and non-efficient of portfolios. Whereas CAL is the special case of CAL in which risk portfolio is the market portfolio. In such case, slop of CML is the Sharpe ratio of market portfolio which mean if the portfolio moves above the capital market line, the risk and expected return in portfolio increase and vice-versa. In general, if the Sharpe ratio is above the CML buy the assets otherwise sell the assets.

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Fig: Capital Market Line (CML) The equation of CML is as follows: Rp=Rf + (RT−rf)*σp/ σT Where, E(Rp) = Expected return of portfolio Rf = Risk free rate σP = Standard deviation of portfolio return σM = Standard deviation of market return E(Rm) = Expected return on market portfolio Features of Capital Market Line 

It represent different combinations of a risk-free asset and market portfolio for a given Sharpe Ratio.

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Slop of CML is the Sharpe ratio of market portfolio

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Efficient frontier represents combinations of risky assets.

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The point of tangency between Capital market line and efficient frontier is the most efficient portfolio.

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the portfolio moves above the capital market line, the risk and expected return in portfolio increase

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the portfolio moves down the capital market line, the risk and expected return in portfolio decrease

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If the Sharpe ratio is above the CML buy the assets otherwise sell the assets

Security Price Behavior under SML and CML CML and SML, both has same assume theory that with the increase of expected return of the securities or portfolios, level of its risk also increase and vice-versa. But has different basis, where SML is based from capital asset pricing model (CAPM) and Capital Market Line (CML) draws its basis from the capital market theory as well as the capital asset pricing model (Thakur, n.d.). Both line are based on the trade-off between risk and return. As both deal with the risk and return, so there might be confusion between these line. CML used to show rate of return under certain level of risk for the specific portfolio whereas SML represent market risk and return time. Under CML, risk is measured through standard deviation and beta coefficient are used to determine risk factor of the SML. SML help to determine whether the individual securities or assets are undervalued or the overvalued. The assets or securities that lies above the SML are undervalue whereas the assets or securities that lies below the SML are overvalue. While evaluating the security return from the SML, the expected rate of return of that individual security is shown at y-axis and total non-diversifiable risk or its beta under that expected rate of return are shown at x-axis (CFI, n.d.). Whereas under CML, expected return of the portfolio is show at y-asix and x-axis is the standard deviation for CML. The graph of CML define the

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efficient portfolios and graph of SML define both efficient and non-efficient portfolios. As both are efficient to measure the expected return but CML is useful while measuring the risk factor as all the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML (Prabhat, 2010).

Inefficient Portfolio Inefficient portfolio are those portfolios that have too low expected rate of return as compare to risk taken. In simple, inefficient portfolio has a poor risk-to-reward ratio (Peters, 2020). Under inefficient portfolio, the investor has to face higher degree of risk in which they either has to accept too low expected returns for the risk endured or has to face too much risk for the size that the investor is expecting. Simple example of inefficient portfolio is the bond that has only expected return of risk free rate but has high yield. In this case, investor can invest in risk free assets which are consider to be more safest investment with no risk. Inefficient portfolio lies under the CML line and below SML line which is consider to be over value securities as the market offer more return then the given portfolio return.

M P

Inefficient

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In the above figure also, we can clearly see the inefficient portfolio point P lies below the CML line that are consider to be overvalue as the market is providing more retune then the given securities.

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Reference CFI. (n.d.). Security Market Line (SML). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/securitymarket-line-sml/ Ganti, A. (2021, March 20). Capital Market Line (CML). Retrieved from https://www.investopedia.com/terms/c/cml.asp Kenton, W. (2020, October 15). Security Market Line (SML). Retrieved from https://www.investopedia.com/terms/s/sml.asp Peters, K. (2020, October 21). Inefficient Portfolio. Retrieved from https://www.investopedia.com/terms/i/inefficient-portfolio.asp Prabhat, S. (2010, February 10). Difference between CML and SML. Retrieved from http://www.differencebetween.net/business/difference-between-cml-andsml/#ixzz6rAlTRiQz Thakur, M. (n.d.). Security Market Line (SML). Retrieved from https://www.wallstreetmojo.com/security-market-line/...