Name: Parmar Jayshri v. - Roll No: 43 - Topic: Capital Market Line and Security Market Line

• Name : parmar jayshri v.
• Roll no : 43
• Class : M.com (sem – 4)
• Topic : capital market line and security

market line
Capital market line
Capital market line
• All investor are assumed to have identical expectation
.hence all of them will face the same efficient frontier
depicted in figure. Every investor will seek to combine
the same risky portfolio B with different level of
lending or borrowing according to his desired level of
risk .because all investors hold same risky portfolio,
then it will include all risky securities in the market .
this portfolio of all risky securities is referred to as the
market portfolio M .Each security will be held in the
proportion which the market value of the security bears
to the total market value of all risky securities in the
market. All investors will hold combination of only
two assets, the market portfolio and a riskless security.
The relation between the return and risk of
any efficient portfolio on the capital market
line can be expressed in the form of following
equation.
Re = R f + R m – R f σe
σm
Cont…
• Where the e denotes an efficient portfolio.
• The risk free return Rf represents the reward for waiting
.it is, in other word, the price of time .
• The term(R m – R f )/ σm .Represents the price of risk or
risk premium ,
• i.e. the excess return earned per unit of risk or standard
deviation. It measures the additional return for an
additional unit of risk .when the risk of the efficient
portfolio , σe is multiplied with this term , we get the
risk premium available for the particular efficient
portfolio under consideration.
Limitation of use
• The key problem of capital market line in real markets
conditions is that CML is based on the same assumptions as
capital asset pricing model(CAPM).
• There are taxes and transaction costs, which can significantly

differ for various investors.
• It is supposed that any investor can ether lend or borrow

unlimited amount at risk-free rate.
• Not all investors are rational and risk-averse.
• There are no risk-free assets.

Security market line
• Definition
• The security market line (SML) is a visual
representation of the capital asset pricing
model or CAPM. It shows the relationship
between the expected return of a security and
its risk measured by its beta coefficient .In
other words, the SML displays the expected
return for any given beta or reflects the risk
associated with any given expected return.
Equation
• SML: (Ri) = Rf + βi (RM – Rf)
• E( Ri) = is the expected return on the security

• Rf = is the risk-free rate and represents the y-
intercept of the SML
• Βi = is a non-diversifiable or systematic risk. It
is the most important factor of SML
• E(RM) = is expected return on market portfolio

M.
• E(RM) – Rf = is known as Market Risk Premium
The security market line
• The CML shows the risk – return relationship for
all efficient portfolios. they would all lie along the
capital market line .All portfolio other than the
efficient ones will lie below the capital market line.
The CML does not describe the risk – return
relationship of inefficient portfolio or of individual
securities. the capital assets pricing model specifies
the relationship between expected return and risk for
all securities and all portfolios, whether efficient or
inefficient.
Con….
• We have seen earlier that the total risk of a security as
measured by standard deviation is composed of two
components. Systematic risk and unsystematic risk or
diversifiable risk. As investment is diversified and more
and more securities are added to a portfolio, the
unsystematic risk is reduced .for a very well diversified
portfolio, unsystematic risk tends to become zero and
the only relevant risk is systematic risk measured by
beta .(β ) Hence ,it is argued that the correct measure of
a security’s risk is beta.
Cont…
• It follows that the expected return of a security
or portfolio should be related to the risk of that
security or portfolio as measured by β. Beta is a
measure of the security ‘s sensitivity to changes
In market return .beta value greater than one
indicates higher sensitivity to market changes ,
whereas beta value less than one indicates lower
sensitive to market changes. A β value of one
indicates that the security moves at the same rate
and in the same direction as the market thus, the β
of the market may be taken as one .
Cont…
Con….
• The x-axis of the SML graph is represented by the beta, and
the y-axis is represented by the expected return. The value of
the risk-free rate is the beginning of the line.
• The zero-beta security will have the expected return equal to
the risk-free rate. The expected return of zero-beta portfolio
also equals the risk-free rate.
• The slope of the security market line is determined by the
market risk premium (RPM), which is the difference between
the expected market return and the risk-free rate.
• The SML is not fixed and can change the slope and y-axis
intersection over time. It depends on changes in interest rates,
risk-return trade-off.
• If the beta coefficient of the given security changes over time,
its position on the line will also change.
Security Market Line Example
Let the risk-free rate be 5% and the expected market return is 14%. Consider two
securities one with a beta coefficient of 0.5 and other with the beta coefficient of
1.5 with respect to the market index
calculating the expected return for each security using SML:
Expected return for Security A as per security market line equation is as per below
E(RA) = Rf + βi [E(RM) – Rf]
E(RA) = 5 + 0.5 [14 – 5]
E(RA) = 5 + 0.5 × 9 = 9.5%
Expected return for Security B:
E(RB) = Rf + βi [E(RM) – Rf]
E(RB) = 5 + 1.5 [14 – 5]
E(RB) = 5 + 1.5 × 9 = 18.5%
Thus, as can be seen above Security A has lower beta thus, it has lower expected
return while security B has higher beta coefficient and has the higher expected
return.
Limitations of Security Market Line (SML)
• The risk-free rate is the yield of short-term government
securities. However, the risk-free rate can change with time
and can have even shorter-term duration thus causing volatility
• Market return is the long-term return from a market index
which includes both capital and dividend payments Market
return could be negative which is generally countered by using
long-term returns.
• Market returns are calculated from past performance which
cannot be taken for granted in the future.
• Major input of SML is the beta coefficient, however,
predicting accurate beta for the model is difficult. Thus, the
reliability of expected returns from SML is questionable if
proper assumptions for calculating beta are not considered.

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• Name : parmar jayshri v.

• Class : M.com (sem – 4)

• Topic : capital market line and security

• There are taxes and transaction costs, which can significantly

• It is supposed that any investor can ether lend or borrow

• Not all investors are rational and risk-averse.

• There are no risk-free assets.

• E( Ri) = is the expected return on the security

• E(RM) = is expected return on market portfolio

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