SML and CML

SML
• Security market line (SML) is the graphical
representation of the Capital asset pricing model.
It displays the expected rate of return of an
individual security as a function of systematic,
non-diversifiable risk (its beta).
• All the correctly priced securities are plotted on
the SML. The assets above the line are
undervalued because for a given amount of risk
(beta), they yield a higher return. The assets
below the line are overvalued because for a given
amount of risk, they yield a lower return.
 Assumptions of CAPM

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 Characteristics Line

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 Security Market Line (SML)

Security market line

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 Security market line with normalize systematic risk

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SML
 Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf

Risk
 Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf

1.0 BETA
SML
 CML
• Capital market line (CML) is the tangent line
drawn from the point of the risk-free asset to
the feasible region for risky assets. The
tangency point M represents the market
portfolio, so named since all rational investors
(minimum variance criterion) should hold
their risky assets in the same proportions as
their weights in the market portfolio.
 The capital market line

The capital market line (CML) is an efficient set of risk-

free and risky securities, and it shows the risk-return trade-off
in the market equilibrium.

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 Separation Theory
• According to the separation theory, the
choice of portfolio involves two separate
steps.
• The first step involves the determination of
the optimum risky portfolio.
• The second step concerns with the investor’s
decision to form portfolio of the risk-free
asset and the optimum risky portfolio
depending on her risk preferences.
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 Slope of CML

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 CML
• The CML results from the combination of the market
portfolio and the risk-free asset (the point L). All
points along the CML have superior risk-return
profiles to any portfolio on the efficient frontier, with
the exception of the Market Portfolio, the point on
the efficient frontier to which the CML is the tangent
(the point M). From a CML perspective, this portfolio
is composed entirely of the risky asset, the market,
and has no holding of the risk free asset, i.e., money
is neither invested in, nor borrowed from the money
market account.
CML