Difference between Security Market Line (SML) and Capital Market Line (CML)

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The security market line (SML) is a graph that is drawn with the values obtained from the capital asset pricing model (CAPM). It is a theoretical presentation of expected returns of assets that are based on systematic risk.

Non-diversifiable risk is not represented by the SML. In a broader sense, the SML shows the expected market returns at a given level of market risk for marketable security. The overall level of risk is measured by the beta of the security against the market level of risk.

Security Market Line Assumptions

Since the security market line is a representation of the CAPM, the assumptions for CAPM are also applicable to SML. The most notable factor is CAPM is a one-factor model that is based only on the level of systematic risk the securities are exposed to.

The more the risk the more are the expected returns that are applicable in CAPM are also applicable in the case of SML.

  • All market investors are risk-averse and they cannot affect the price of a security.

  • The investment scope for all investors is the same.

  • No short sales take place in the market.

  • No taxes or transaction costs are applicable.

  • Only one risk-free asset is there in the portfolio

  • There are numerous risky assets.

  • All market participants have access to all necessary information.

The Capital Market Line (CML)

Capital Market Line (CML) represents the portfolios that accurately combine both risk and return. It is a graphical representation that shows s a portfolio’s expected return based on a particular level of risk given.

The portfolios on the CML optimize the risk and return relationship. it maximizes the performance. The slope CML is called the Sharpe Ratio of the portfolio. It is usually popularly discussed among investors that one should buy assets if the Sharpe ratio is above the CML and sell if the ratio falls below the CML.

Drawbacks of CML

  • Presence of friction − CML considers that there is always some friction in the market irrespective of the volume and size.

  • Taxes and transaction costs − Taxes and transaction costs are needed to be paid by the investors and these costs can vary from person to person and also in different geographies.

  • The difference in investors worldwide − In the practical world, all investors do not have access to all the information required to make a good investment decision Moreover, CML takes into consideration that all investors will behave rationally, which is not necessary all of the time.

  • Absence of risk-free asset − The CML concept is built on the principle of the existence of risk-free assets. In reality, there is hardly any asset that is a risk-free asset.

Difference between SML and CML

The security line is derived from the capital market line. CML is used to see a specific portfolio’s rate of return while the SML shows a market risk and a given time’s return. SML also shows the anticipated returns of individual assets.

CML shows the total risk and measures it in terms of the SML (beta or systematic risk). Fair-priced securities are always plotted on the SML and CML. The notable factor is that the securities which generate higher results for a certain risk, are usually found above the SML or CML, and they are always underpriced and vice versa.

raja
Updated on 29-Sep-2021 06:14:04

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