Discuss the differences and similarities between the security market line (SML) and capital market line (CML).© BrainMass Inc. brainmass.com December 24, 2021, 7:56 pm ad1c9bdddf
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CML plots expected return as function of portfolio volatility; SML plots expected return as function of beta. Both are risk/return but CML is total risk and SML is systematic risk
Both are anchored on y-axis at the riskless portfolio; i.e., a riskless asset/portfolio offers neither volatility nor systematic risk. Both contain the market portfolio. On the SML, the market portfolio is located, by definition, where beta equals 1.0.
The SML says an asset/portfolio's expected excess return (excess return = expected return - riskless rate) is proportional to its systematic risk. So, this is a single-factor model where the single-factor is sensitivity, as measured by beta, to the equity risk premium (ERP). ERP is also called the price of risk; beta is also called the quantity of risk. So, CAPM says: security's expected excess return = quantity of risk * price of risk.
Beta is covariance (instrument, portfolio)/variance (portfolio). It is also the same as the optimal hedge ratio, as both are slope metrics (see beta is one idea with many faces)
Security market line or SML can be defined as the graphical representation of CAPM whereas CML is a line used in the CAMP to demonstrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.
Reference: http://www.investopedia.com/terms/c/cml.asp.© BrainMass Inc. brainmass.com December 24, 2021, 7:56 pm ad1c9bdddf>