CML VS SML | Capital Market Line(CML) and Security Market Line(SML)| Investment Decisions | Finance
Capital Market Line(CML) is the graphical representation of CAPM which shows the relationship between the expected return on the efficient portfolio and their total risk.
Security Market Line(SML) is the graphical representation of CAPM which shows the relationship between the required return on individual security as a function of systematic, non-diversifiable risk.
In the condition of market equilibrium, all the securities lie on the Security Market Line (SML). Therefore, the SML has asset price implication for both portfolios and individual securities. The securities lying above SML are said to be underpriced securities as it indicates that return from the security is greater than what is required to compensate for the systematic risk associated with the security.
On the other, hand the securities lying below SML is said to be overpriced securities as it fails to give sufficient return to compensate against the systematic risk associated with the security. On the basis of the asset pricing implication shown by the Security Market Line (SML), investors preferred to buy all underpriced securities and sell overpriced securities.
CML VS SML
| S. No. | Capital Market Line(CML) | Security Market Line(SML) |
Meaning |
Capital Market Line(CML) is the graphical representation of CAPM which shows the relationship between the expected return on the efficient portfolio and their total risk. | Security Market Line(SML) is the graphical representation of CAPM which shows the relationship between the required return on individual security as a function of systematic, non-diversifiable risk. |
Measures |
Capital Market Line(CML) measures the risk through standard deviation, or through a total risk factor. | Security Market Line(SML) measures the risk through beta, which helps to find the security’s risk contribution to the portfolio. |
Graph |
The graphs of the Capital Market Line defines efficient portfolios. | The graphs of the Security Market Line define both efficient and non-efficient portfolios. |
X-Axis & Y-Axis |
The Y-axis of the CML represents the expected return and X-axis represents the standard deviation or level of risk. | The Y-axis of the SML represents the level of the required return on individual assets, and the X-axis shows the level of risk represented by beta. |
Why must all assets plot directly on it in a well-functioning market?
The security market line is a positively sloped line displaying the relationship between the required return from security for each given level of non-diversifiable risk(beta). The slope of the line [E(Rm) – Rf] is the market risk premium.
In a well-functioning market/competitive market, a market portfolio is made up of all these assets, so, all the assets must plot on the SML.
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MBA,BBA.
I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,
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Realized a bunch. Very easy to understand. Thanks for sharing with us 🙂
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